Pricing > Interest and Financing > Interest Rates
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Interest Rates
What are Interest Rates?
(If you are looking for information on margin interest rates please click here.)
An interest rate is a fee paid by the borrower of an asset to the owner of an asset. Interest rates are typically expressed as a percentage of the principal amount or asset value.
For consumer goods, interest rates act as usage fees or leasing charges to the borrower for the use of the good.
For securities, such as bonds, interest rates act as an inflationary tag added to an asset representing a change in value over time. This change in value is associated with the natural fluctuation of currencies.
The Federal Funds Rate & Banks
The Federal Reserve is the central banking system of the United States and the world’s most influential financial institution. A controlling board of regulators and bank presidents (known as the Federal Open Market Committee or FOMC for short) set the Federal Funds Rate, which is the interest rate at which banks are able to lend balances to other depository institutions. The Federal Funds Rate (commonly referred to as the Fed funds rate) in turn influences the interest rate on securities.
Banks pay interest to depositors for the use of deposited funds. In this arraignment, the bank is the borrowing party and the depositor is the lending party. Interest rates, as they pertain to bonds, act in a similar manner. The rate of interest accruing on deposits represents the bank’s ability to guarantee the availability of those funds at any future date.
Interest Rates & Risk
The most important thing to understand about interest rates is their relationship to risk. In this case, risk is defined by the ability of a borrower to repay the full value of the asset borrowed.
The more risk associated with a borrowing party’s ability to pay back its loan, the higher the interest rate added to the principal. Similarly, if a lender deems a borrower to be of little risk, then the interest rate charged will be lower. Therefore, the amount a lender charges a borrowing party in interest is directly proportionate to the amount of risk the lender assumes by allowing the use of an asset.
Interest Rates & Bonds
A bond is a promissory security issued by either a government or a corporation that guarantees future payment at a rate of interest for the borrowing of funds. Essentially, bonds are the temporary sale of debt by an organization to raise funds. The length of time until a bond matures, meaning the amount of time until the bond is repaid, determines the rate of interest that is paid.
When a government or corporation issues a bond, they accept money from the buyer (aka the lender), and in return promise to repay that money at an equivalent future value. Generally speaking, the more time it takes for a bond to mature, the higher the rate of interest paid. It is in this way that interest rates on bonds act as inflationary tags.
There is an inverse relationship between interest rates and the price of bonds. What does that actually mean?
This means that bond prices and interest rates move in opposite directions or simply when one goes up, the other goes down.
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If a bond issuer is deemed less-than-capable of repaying a loan, the principal value of the bonds being issued is diminished. The issuer of the bond then sells off lower value securities but promises a higher rate of interest. The promise of an increased rate of return is meant primarily to attract investors who would otherwise be less apt to participate in a high-risk investment. Therefore, the principal value of a bond works inversely with the amount of interest assessed. As bond prices increase, interest rates decrease because they are a safer bet. Likewise, as bond prices decrease, interest rates increase to offset the potential risk of default.
Learn more about investing in Bonds at Place Trade
Additional Resources
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Please Note:
The following resources that will take you away from Place Trade*
Data Releases from the Board of Governors of the Federal Reserve System
Why Central Banks and Interest Rates are so Important Understanding Interest-Rate Risk Interest Rate Risk—When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall Investor Bulletin: The ABCs of Credit Ratings
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*(Please note: we are not responsible for the content or links of third party websites.)
