Tag Archives: Interest

19Dec/11

What is a bond spread?

A bond spread is the difference between the yields of two bonds with different credit ratings.  The differing ratings are usually because of different levels of risk involved with the bonds.  Mathematically, you can calculate the spread by subtracting the interest rate of one bond from the interest rate of the other.  For example, if the current yield on a bond that Microsoft is offering is 6.1% and a federal bond has a current yield of 5.9%, the two bonds would have a .2% spread.

So, how can you use this information as an investor?  If you look at the spread over time, you should be able to find abnormalities in the spread.  These abnormalities could be buying or selling opportunities.

07Nov/11

What is the difference between a real interest rate and a nominal interest rate?

In our current economic conditions, it is important to understand interest rates.  If you do not understand what the actual cost of borrowing of lending money is, you could be cheating yourself out of profits.  Let’s start by defining nominal interest rates.  The nominal interest rate is the market interest rate before an adjustment for inflation.  Based upon that, you could probably guess what the real interest rate would be.  The real interest rate is the nominal interest rate minus the rate of inflation.  The rate of inflation that you use could be the current rate or your expectation of what the rate will be in the future.  The nominal rate is what you will see when you look at your bank’s website.

Currently, my bank is quoting 3.89% for a 12-year fixed-rate home loan.  According to inflationdata.com, the inflation rate in August 2011 (most recent available data) was 3.77%.  This means that the 12 loan has a nominal interest rate of 3.89% and a real interest rate of 0.12%.  So, if you take out this loan, you it will cost you 0.12%.  As of writing this, the rate on a 6 month CD is 0.23%.  If you convert that to a real interest rate, using the same 3.77% inflation rate, you are paying 3.54% for the privilege of having the bank hold your money.

Next time you are planning out your next investment, take a moment to think about what the real interest rate is.

31Oct/11

What is the London Interbank Offer Rate (LIBOR)?

Today, we are going to be looking into the world of international finance.  The London Interbank Offer Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market (source).  The LIBOR is fixed on a daily basis by the British Bankers’ Association.  The BBA polls the contributing banks on a daily basis.  The BBA website states that “every contributor bank is asked to base their bbalibor submissions on the following question; ‘At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?'”  The BBA then bases the set of rates on the submissions from the banks.  Submissions are not based upon actual transactions due to the fact that transactions “in a reasonable market size” do not necessarily happen every day.

So, the LIBOR is a guide to what banks should expect to pay, in order to borrow funds “in a reasonable market size” in the London interbank market.  So, how does this effect me?  According to the BBA website, the LIBOR is the primary benchmark for short term interest rates globally. It is used as a barometer to measure strain in money markets and often as a gauge of the market’s expectation of future central bank interest rates.  According to the third edition of Corporate Finance: Core Principles & Applications, the LIBOR is a cornerstone in the pricing of money market issues and other short-term debt issues by both governments and corporate borrowers.