Interest Rates

Think of interest rates as the price you pay for using someone else’s money, or someone else pays you for using your money.

Interest rates are the cost of using money, or your return if someone else is using your money. They are very important factor in different valuation methods, as well as in pricing different securities.

You should be familiar with the concept of rates, meaning that you should know how they are used, and why they differ.

Basis Points

Basis point is just another measurement unit for expressing interest rates. 1% equals to 100 basis points (bp or bps). So, if you hear that somebody is charging 500 basis points for a loan, it is nothing more than the other way of saying that somebody is charging 5% interest rate.

Risk-free Rate

Risk-free rate refers to the rate you can earn if you invest in treasury securities (issued by the government). It is called risk-free because you are almost guaranteed to get your money back. However, because of that certainty, the risk-free rate tends to be the lowest rate possible. Typically, investors look at the 10 year or 30 year United States treasury rate as the risk-free rate.

LIBOR

LIBOR stands for London Interbank Offered Rate and it is the rate that major banks charge each other for short-term loans. It is frequently used as a benchmark to calculate interest rates on different loans across the world.

Corporate Rate

Corporate rate refers to the rate you can earn if you invest in corporate bonds (borrow money to a company). Since there is a chance that the company might go bankrupt and not repay you, these rates are higher than risk-free rates.

Credit Spread

Credit spread is the difference between the risk-free rate or LIBOR and the rate of corporate bonds. If the risk-free rate is 4%, and the corporate rate is 10%, the credit spread is 6% (10% – 4% = 6%). Sometimes, interest rates will be quoted in “L + Spread” terms. In our example, since LIBOR is 4%, the loan would be quoted at L + 600bps (or L + 6%).

Fixed rate vs. Floating Rate

If a bank charges a specific interest rate (e.g. 7% or 10%), that rate is called fixed rate because it will be 7% or 10% throughout the life of the loan.

On the other hand, if a bank charges an L + 600bps rate, this rate is considered floating because LIBOR can change at any point in time.

Yield to Maturity (YTM)

Yield to maturity refers to what rate you are earning on your bonds. In other words, it shows you how much money you earned on your investment in bonds. YTM is often used instead of the price. So, instead of saying that a bond costs $934, you say it trades at 7%.