Introduction to Finance

Johnathan Tao

CUHK

July 30, 2024

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 Financial Market

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Real Assets versus Financial Assets

• Real Assets
– A society’s material wealth is determined by its economy’s productive capacity, which
depends on real assets like Land, Buildings, Machines, and Knowledge used to produce
goods and services.
• Financial Assets
– In contrast to real assets, financial assets like Stocks, Derivatives and Bonds are merely
paper or computer entries and do not directly enhance the economy’s productive
capacity. Instead, they represent claims on real assets for individuals.
• While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. Individuals can choose between consuming
their wealth today or investing for the future.
• The distinction between real and financial assets is apparent in the balance sheet. For
example, a bond that you treat as an asset is a liability of the issuing company, which is
obligated to make the payments to you.
• Your asset is company’s liability. Therefore, when we aggregate over all balance sheets,
these claims cancel out, leaving only real assets as the net wealth of the economy. National
wealth consists of structures, equipment, inventories of goods, and land.

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Investable Assets

• The assets for investors in the financial market are mainly liquid investable assets such as
bonds, stocks, foreign currencies and commodities.
• A transferable asset traded in the market is often identified by a code given by a
well-recognized institution.
• For example, the The Goldman Sachs Group stock, has a RIC (Reuters Instrument Code) of
“GS.N”, an ISIN (International Securities Identification Number) code of “US38141G1040”
and a BBGID (Bloomberg Global Identifier) of “GS:US”.
• The basic types of securities are debts and equities, which are directly linked to economic
activities. Debt securities take the form of bonds, bills, etc. Equity securities issued by
corporations are called stocks or shares, representing claims of ownership in the corporation.

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Financial Instruments

A financial instrument is a general term for a monetary contract between parties. It can either
be:
• a cash instrument, whose value is directly determined by the market (e.g., stocks, bonds)
• or a derivative instrument (or simply, derivative), whose payoff is derived from the
price or level of the underlying asset or reference (called underlier or underlying for
simplicity) such as equity security, fixed-income security, foreign currency, commodity,
or interest rate.
• The most common derivatives are forward/futures contracts, swaps and options.

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Example of Derivative Instrument

Derivative Example ELN Product

Tenor 1 month (32 days)
Trade Date 28 May 2024
Settlement Date 11 Jun 2024
Maturity Date 13 Jul 2024
Spot HK$ 350.8
Strike Level 92% of Spot
Note Price 98.76%
Yield 14.32% p.a.
Underlying Share Tencent (0700.HK)
Maturity Payoff If ST ą K ˆ S0 , Investors receive N (a return of 14.32% p.a.);
If ST ă K ˆ S0 , Investors receive N/(K ˆ S0 ) shares of stock.

Table: Derivative Instrument

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Investment Returns

A The investment return of a non-dividend paying asset for the period between time s and
time t (s < t), is defined as:
Pt ´ Ps Pt
R= or R= ´ 1, where Pt is the price of the asset at time t.
Ps Ps
The return rate is an annualized concept in general. There are different types of return rates.
For instance, the IRR (Internal Rate of Return) is the value of r which makes the following
equality:

Pt = Ps (1 + r)σ , where σ represents the number of years for period [s, t].
Usual measures for the rate of return of an asset or a portfolio are:
• Price return: it is measured by the portfolio’s value at the beginning and the end of the
period. The dividend are ignored.
• Total return: it is obtained with all the dividends re-invested back into the assets of the
portfolio with the same proportion. It represents the return of a fully funded portfolio.
• Excess return: It is defined as the portfolio’s total return minus the financing cost or a
relevant interest rate reference. It represents the return of a self-financed portfolio.

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Example

Consider two assets: Asset 1 and Asset 2. Asset 2 pays a $1 dividend per unit at time t . The
financing cost is 1% on the borrowed amount.

Ps Pt Price return Total return Excess return

Asset 1 19 20 5.26% 5.26% 4.26%
Asset 2 90 99 10% 11.11% 10.11%

Table: Example of Asset Returns

( )
99 + 1
Note that the total return for Asset 2 is calculated from ´ 1 , i.e., assuming that
90
the $1 dividend per unit of the asset is reinvested.

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Some Frequently Used Words

• In financial market, the term long means “in the possession of” and the term short means the
opposite. A long position of an asset will realize a profit if the asset price goes up and suffer
a loss if the asset price drops.

• The short position of an asset will realize a profit if the asset’s price drops and lose money if
the asset’s price goes up. The short position can be built by borrowing the asset and then
selling it to the market. For closing the short position, the asset must be bought back and
returned to the asset lender.

• Financial analysts use the words “bull/bullish” and “bear/bearish” for describing the rising
trend and falling trend of the price of the assets. The term arbitrage used in finance refers to
the transactions leading to a risk-free profit.

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Financial Transaction

The buy/sell transaction life cycle of a cash security such as bond or stock is characterized by
order placing, execution and clearing/settlement. For a derivative trade, there are also
valuation, cash flow/securities transfer, and corporate actions to handle until the trade
termination. The following concepts are related to the life cycle of a financial transaction.
• Order Type: the condition to buy/sell securities in the market. The usual ones include limit
order, market order, will talk more later in slide 3.
• Trade Size: the amount, either in currency units or in securities units, used to determine the
payment amount or the quantity of securities to deliver.
– Face Value or Denomination: often used for securities;
– Notional or Nominal: usually used in derivatives contracts without payment of the
amount;
– Principal: when there is payment of the amount.
• Trade Date: the date on which an order is executed, or a financial contract is concluded.
The initial reference and strike prices are determined upon order execution.
• Tenor: the life time of a trade. In money market, there are one business day tenor
transactions including O/N (Overnight), T/N (Tom/Next, from next business day to the
following one), S/N (Spot/Next, from spot date to the following business day). The spot date
for most of the currencies is T + 2 where T stands for trade date.
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Financial Transaction - Cont

• Value Date: the date on which the currency or security units involved in a transaction take
effect or change ownership.
• Expiration Date: the last day to exercise the right in a derivative instrument. It is often used
as the last valuation date.
• Maturity Date: on which the validity of a financial instrument ends.
• Payoff: the realized cash flows or delivered securities for the long party of a derivative
instrument during the whole period after its inception until the expiration date.
• Fixing Date: the date on which the price, rate or other reference level to be used in financial
calculation is determined.
• Clearing: the process of establishing final positions for settlement, including confirming
instructions, reconciliation, netting, etc. Usually conducted by a clearing house;
– Netting: payment netting combines multiple payments between two counterparties into
a single net payment, reducing the total amount if there are offsetting payments.
– Settlement: the delivery of securities or fund units; There are DvP (delivery versus
payment) method and FoP (free of payment) method.
– Custody: safekeeping of securities by a custodian bank or a depositary institution.

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Financial Transaction - Cont

• Collateral: assets (cash, securities, etc.) serving as guarantee for a liability.

• Corporate Action: usually initiated by the issuer of a security (a stock or a bond), a

corporate action normally has ownership or financial impact. Examples include dividend,
rights issue, merger, stock split, and shares buy-back.

• Valuation: the process of determining the mark-to-market price for accounting, termination
or unwinding payments, counterparty risk exposure, etc. For an OTC transaction, a
calculation agent must be specified to perform the valuation. For structured products, the
product provider is usually the calculation agent.

• Valuation Date: on which a valuation is carried out.

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Performance Measures

There are many indicators that are used for measuring the performance of an investment
strategy or an investment fund (aggregated form of investment) other than its total return R.
The most popular ones include
• Sharpe ratio = (R ´ r)/“standard deviation of (R ´ r)”, where r is the return of a
risk-free investment.
• Information ratio = (R ´ RBM )/“standard deviation of (R ´ RBM )”, where RBM is the
return of the relevant benchmark (e.g. an equity index, if the investment portfolio is
composed of stocks).
• Sortino ratio = (R ´ r)/“downside deviation”, where “downside deviation” is the
standard deviation obtained with negative returns only.
• Maximum drawdown: the peak-to-trough decline in percentage during the considered
period of an investment. For the considered period [t1 , t2 ], it is defined as

m(t̂, t2 )
´ 1,
M(t1 , t2 )

where M(t1 , t2 ) is the highest price which is achieved at time t̂, and m(t̂, t2 ) is the lowest
price after t̂.

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Financial Markets and the Economy

• The Informational Role of Financial Markets

– Stock prices reflect investors’ collective assessment of a firm’s performance and future
prospects. When optimism rises, so does the share price.
– Higher prices make it easier for firms to raise capital, encouraging investment. Thus,
stock prices play a key role in capital allocation, directing funds to firms with the
greatest perceived potential.
• Consumption Timing
– Financial assets enable individuals to shift purchasing power from high-earnings to
low-earnings periods. By investing savings in assets like stocks and bonds during
high-earnings periods and selling them during low-earnings periods.
– Individuals can balance consumption over their lifetime, maximizing satisfaction. This
allows current consumption decisions to be independent of current earnings constraints.
• Allocation of Risk
– Financial markets allow risk to be distributed according to investors’ risk tolerance. For
example, Tesla can fund an auto plant by selling stocks to risk-tolerant investors and
bonds to conservative ones.
– This risk allocation benefits firms by enabling them to raise capital more efficiently, as
securities can be sold at optimal prices, thereby supporting the growth of real assets in
the economy.
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Financial Market

• Financial Market designates the aggregate of participants, organizations and facilities in

which people trade financial securities (stocks, bonds...), commodities (precious metals,
industrial metals, energy products, agricultural products...) at prices that reflect supply and
demand.
• The financial market can be detailed by the type of services it offers:
– Capital Market: provides financing through the issuance of shares and debts, and
enable the subsequent trading, it can be separate into

* Stock Market: for financing with equity

* Bond Market: for long term debt financing with bond or note;
– Money Market: for short-term (up to 1 year) debt instruments;
– Fixed-Income Market: for all interest rate and credit related cash or derivative
instruments;
– Equity Market: for all stock and equity index related cash or derivative instruments;
– Foreign Exchange Market: for foreign exchange related instruments;
– Commodities Market: for commodities instruments.

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Investment Bank Business Segments

GLOBAL BANKING & ASSET & WEALTH PLATFORM SOLUTIONS

MARKETS MANAGEMENT

Investment banking fees Management and other fees Consumer platforms

– Advisory Incentive fees Transaction banking and other
– Equity underwriting Private banking and lending
– Debt underwriting
Equity investments
FICC
Debt investments
– FICC intermediation
– FICC financing
Equities
– Equities intermediation
– Equities financing
Other

Table: Goldman Sachs Business Segments

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Financial Market Classification

• The financial market can also be classified in other different ways:

– New issuance versus Seasoned Securities:

* Primary Market: where new issues are first sold through IPOs (initial public
offerings);

* Secondary Market: for all subsequent trading after IPO between market
participants (institutional or individual investors).

– Market Organization:

* Listed Market: Public Auction Market such as Stock Exchanges: Shanghai Stock
Exchange (SSE), New York Stock Exchange (NYSE), NASDAQ, Hong Kong
Stock Exchange (HKEX). The exchanges are usually private companies and may
be listed themselves;

* OTC (Over-The-Counter) Market: where buy/sell contracts are made between

the two counterparties. OTC market is often animated by brokers as intermediary
agents.

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Financial Market - Central Clearing Counterparty

• As an OTC derivative involves potential payments between the parties in the future, the
counterparty risk that one party does not pay as obligated in the contract can not be neglected.
• To mitigate the counterparty risk, the long and short parties of a derivative contract may
transact with the “Central Clearing House” which covers the risk by a collateral deposit
system known as the margining system.
• When a CCP is involved in a transaction agreed by two parties, either directly or
anonymously, the transaction is carried out by two legal contracts, one between the buyer
and the CCP while the other one between the seller and the CCP.
• CCP takes counterparty risk of the parties, which is mitigated by collateral management.
• After the 2008 financial crisis, CCP proved resilient during the Lehman Brothers default. As
a result, regulators mandated CCP for standardised OTC derivatives and imposed margining
and higher capital charges on non-centrally cleared contracts to incentivize CCP clearing.
• This led to widespread global adoption of CCP for listed derivatives and cash/securities
markets, particularly in developed markets.

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Bilateral Trading and CCP Clearing

• CCP clearing is different from Bilateral Trading. It

– Acts as seller to every buyer and buyer to every seller.
– Insures clearing members against counterparty losses by taking on the positions of the
defaulted member.
– Nets down payment obligations across all the cleared contracts to one payment
obligation to the CCP per member.
– Takes in collateral to guarantee contractual performance.
– Enables risk mutualization among its members through a guaranty fund/default fund.
• CCP is a key element of the post-trading process and an integral part of payment and
settlement systems.

Member 1 Member 1

Member 6 Member 2 Member 6 Member 2

CCP

Member 5 Member 3 Member 5 Member 3

Member 4 Member 4

BILATERAL TRADING CENTRAL CLEARING

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Counterparty Risk Management

• To mitigate counterparty credit risks, there are usually two types of margins that are required
in a derivative trade:
– Initial margin: collateral taken at inception and kept until termination of the trade, to
mitigate close-out risk for default (e.g., based on the analysis of price movements in 2
weeks)
– Variation margin: amount received or paid daily over the whole life of the trade
reflecting the market-to-market value change of the derivative transaction. There are
two models for variation margin:

* Settlement-to-market (STM): MtM exposure is settled with effective payment on

daily basis. It is generally used by the exchanges

* Collateralized-to-market (CTM): it consists of posting collateral to the positive

MtM party. Any income generated by the collateral belongs to the collateral poster.
The contracts under ISDA/CSA generally follow the CTM model currently.

N contracts N contracts
Seller Clearing Houseof the Exchange Buyer
daily margin daily margin

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Repurchase Agreement

“China’s central bank conducted 2 billion yuan ($281.57 million) in seven-day reverse repos
at an interest rate of 1.8 percent on Monday.”
• We often hear such reports in financial news, but what exactly are repo and reverse repo
operations? What impact do they have on the economy?
• A repurchase agreement is a contract for the sale of a security (e.g. stock or bond) with a
commitment by the seller to buy the same security back from the buyer at a specified price at
a future date.
• During the tenor of the trade, the seller (also called the lender) of the security surrenders the
legal ownership of the security.

Collateral
Party A(Cash borrower) Party B(Cash lender)
Cash
Under GMRA (Global Master Repurchase Agreement)
Collateral
Party A(Cash borrower) Party B(Cash lender)
Cash + Interest

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US O/N Reverse Repo Versus S&P 500

Figure: US O/N Reverse Repo Versus S&P 500 from July 31, 2014

* U.S. reverse repo is defined as Selling Treasury Securities by the Federal Reserve in the
Temporary Open Market Operations, which is the opposite of definition used in China
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Reserve Balances System

• Interest on Reserve Balances (IORB): IORB is the interest rate paid by the Federal
Reserve to depository institutions on their reserve balances, which include both required
reserves and excess reserves. Starting from July 29, 2021, the Federal Reserve merged IOER
(Interest Rate on Excess Reserves) and IORR (Interest Rate on Required Reserves) into
IORB as a unified rate tool.
– Previously, IOER was the interest rate paid by the Federal Reserve to depository
institutions on reserves held in excess of the required amount.
• In March 2020, the Federal Reserve eliminated the reserve requirement ratio for commercial
banks, setting it to 0%. As a result, there is no longer a need to distinguish between required
reserves and excess reserves, nor between IORR and IOER. This simplification also makes
interest calculations easier. Before the merger, the interest calculation formula was:

Interest = IORR ˆ Required Reserve Balance + IOER ˆ Excess Reserve Balance

• After the merger, the interest calculation formula is:

Interest = IORB ˆ Total Reserve Balance

• This change was mainly in response to the financial market turbulence and liquidity stress
triggered by the COVID-19 pandemic. This action releases bank funds, increases the banks’
ability to generate credit, and lowers their loan costs, thereby supporting the real economy.

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Excess Reserves Versus M2 in the U.S.

Figure: Excess Reserves and M2 in the U.S.

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Quantitative Easing (QE)

• Under normal circumstances, the Federal Reserve responds to economic recessions by

lowering the federal funds rate (FFR) target. This is the rate at which banks lend to each
other overnight. However, by the end of 2008, the Fed had already lowered the FFR to zero,
which meant that the Fed’s usual monetary mechanism for reversing economic crises had
been maximally utilized.
• To prevent the economy depression, the Fed turned to a new tool called Quantitative Easing
(QE). Because controlling interest rates is conventional monetary policy, quantitative easing
is referred to as unconventional monetary policy. Its mechanism can be described as:
– The Fed directly purchased large amounts of assets from banks. For example,
mortgage-backed securities (MBS) and U.S. Treasury bonds.
– The newly created funds were deposited into their reserve accounts at the Fed This
provided banks with more funds than the minimum reserve requirements. The money
base increased, banks gained more funds, which in turn helped support banks’ unstable
financial conditions and encouraged them to provide more loans.

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Quantitative Easing (QE) - Cont

• Between 2008 and 2014, the Fed expanded its balance sheet by $4.5 trillion in this way
• From 2008 to 2012, the figure shows that the excess reserves of depository institutions saw
three significant increases, corresponding to QE1, QE2, and QE3. However, M2, as a
measure of actual funds interacting with people and businesses in real world, grew more
moderately, largely consistent with past historical trends.
• This indicates that the money released by the Fed did not directly enter actual economic life.
• During an economic recession, when there is idle capacity and low output, banks won’t be
willing to lend out the additional funds provided by the Fed. Businesses will also be
unwilling to borrow because they are pessimistic about the future. Although the central bank
increased the monetary base, it was essentially stored away rather than spent.
• By the end of 2014, the excess reserves had reached a historical high, the Fed had to reduce
its balance sheet and withdraw some reserves. From 2015 to before the pandemic in 2020,
the Fed was continuously reducing its balance sheet, and also the excess reserves.
• However, COVID-19 in 2020 directly forced the Fed, which was far from completing its
balance sheet reduction goal, to release more reserves again, and this time the magnitude was
so large that it reached the amount of the three times from 2008-2012 in one go.
• Question: Why the 2020 QE has results in M2 growing along with excess reserves?

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Floor System in Monetary Policy

After 2008, the Federal Reserve released trillions of dollars of liquidity through several
rounds of QE. Under the pressure of massive liquidity, the Federal Reserve was no longer
able to control interest rates by adjusting the amount of liquidity as it had done in the past.
• Initial Floor System: The Federal Reserve initially used the Interest on Excess Reserves
(IOER) as a “floor rate” for the Federal Funds Rate (FFR), aiming to ensure banks would not
lend below this rate. However, IOER mainly influenced interbank rates
– Government-Sponsored Enterprises (GSEs) like the Federal Home Loan Banks (FHLB)
and Fannie Mae and Freddie Mac, Money Market Funds (MMFs). They hold
substantial funds but ineligible for earning interest from the IOER.
– Foreign banking organizations (FBOs) in the U.S. therefore engage in “IOER-FFR
arbitrage” by borrowing at low interest from GSEs and lending to the Fed.
– This has resulted in the Effective Federal Fund Rate (EFFR) consistently being 5 to 20
basis points below IOER, rendering IOER ineffective as a true “floor”.
• Modified Floor System: To address persistent liquidity and control short-term rates
effectively, in 2013 the Fed introduced the Overnight Reverse Repurchase Agreement (ON
RRP) Rate as a more robust floor in the money market.
– This rate involves various market participants, including banks, GSEs, and MMFs.
– The ON RRP Rate acts as a reliable floor by providing nearly risk-free investment
opportunities, thus setting a baseline for other money market rates.

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Arbritage Space between IOER and EFFR

Figure: IOER Versus EFFR

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EFFR Versus ON RRP Rate

Figure: The ON RRP Rate is the True Floor

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Corridors System in Monetary Policy

• The Federal Reserve’s interest rate corridor mechanism is the Fed’s strategy of influencing
the federal funds rate (FFR) target range by establishing two key rates: the overnight reverse
repurchase agreement (ON RRP) rate as the lower bound and the interest rate on reserve
balances (IORB) as the upper bound.
• How does this mechanism work in practice? Let’s consider an example:
– the Federal Reserve currently sets the federal funds rate (FFR) target range at
5.25%-5.50% (June 12, 2024). The ON RRP is the lower limit of 5.25% (In fact, the
ON RRP rate is 5.30% as of July 30, 2024), and the IORB is the upper limit of 5.50%
(In fact, the IORB is 5.40% as of July 30, 2024).
– When the market interest rate falls below 5.30%, say to 5.20%, non-depository
institutions participate in the Fed’s overnight reverse repurchase at 5.30% instead of
lending in the market. This decreases the supply of funds, causing market rates to rise
back towards 5.30%.
– Conversely, when the market interest rate exceeds 5.40%, say to 6.00%, depository
institutions borrow from the Fed at the IORB rate of 5.40% rather than from the
market. This reduces market demand for funds, pulling rates down towards the 5.40%
upper bound.

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Corridors of IORB and ON RRP

Figure: EFFR Falls in the Range Between IORB and ON RRP

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Securities Borrowing & Lending (SBL)

• Securities Borrowing and Lending (SBL) is a process where securities are temporarily
transferred from one party (the lender) to another (the borrower) with the agreement that the
borrower will return equivalent securities at a later date.
• SBL is commonly used for short selling, hedging, or meeting settlement obligations.
• Parties
– Lender: Typically institutional investors, such as pension funds or mutual funds, who
lend securities to earn additional income.
– Borrower: Often hedge funds or traders who need to borrow securities to short sell or
for other trading strategies.
• Collateral: The borrower provides collateral to the lender, which can be cash or other
securities, to secure the loan. The value of the collateral typically exceeds the value of the
borrowed securities to protect the lender against default.
• Fees: The borrower pays a fee to the lender for the duration of the loan. This fee is negotiated
between the parties and can vary based on the demand and supply of the securities.
• Recall and Return: The lender has the right to recall the securities at any time, and the
borrower must return them within a specified period. The borrower can also return the
securities before the recall.

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Day Count Conventions

• A day count convention determines the time period in years to be used for calculating the
interest for the investment in financial instruments, and also for calculating the present-value
of financial assets through discounting.

• General Formula for 30/360 Methods

360 ˆ (Y2 ´ Y1 ) + 30 ˆ (M2 ´ M1 ) + (D2 ´ D1 )

Day Count Fraction =
360
• Examples:

– 30/360 (30/360 US, Bond basis) • If D1 is 31, then change D1 to 30. • If D2 is 31 and D1 is
30 or 31, then change D2 to 30.

– 30E/360 (Eurobond basis) • If D1 is 31, then change D1 to 30. • If D2 is 31, then change D2
to 30.

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Day Count Conventions

ACT Methods

• ACT/360 (Money Market basis, Actual 360, or French)

(d2 ´ d1 )/360 where (d2 ´ d1 ) is the number of days between the two dates.

• ACT/365 Fixed (English Money Market basis)

(d2 ´ d1 )/365

• ACT/ACT ISDA

Days in a non-leap year Days in a leap year

+
365 366

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Business Day Conventions

A business day convention specifies the adjustment when a date is not a business day. It is
used in financial contracts.

• Following: The adjusted date is the following business day.

• Preceding: The adjusted date is the preceding business day.

• Modified Following: The adjusted date is the following business day unless the day is in the
next calendar month, in which case the adjusted date is the preceding business day. This is
the most used convention for interest rate derivatives.

Example:

Start date 30-Aug-2023, period 1 month:

With “Modified Followin”, the end date is Friday, 29-Sep-2023.

With “Following”, the end date is Monday, 2-Oct-2023.

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Real and Nominal Rates of Interest

An interest rate is a promised rate of return denominated in some unit of account (dollars,
yen, euros) over some time period.
When stating a 5% interest rate, both the unit of account and time period must be specified.
An interest rate risk-free in one unit or period may not be risk-free in others. For instance, a
dollar-denominated interest rate might be safe but risky in terms of purchasing power due to
inflation uncertainty.
Real and Nominal Interest Rates
rnom ´i
• Exact formula: rreal = 1+i , i is the rate of inflation

• Approximation: rreal « rnom ´ i, overstates the real rate by factor 1 + i

Fixed income investments like bank CDs promise a nominal interest rate. Due to uncertain
future inflation, the real return is risky even if the nominal rate is risk-free.
Investors would expect higher nominal interest rates if inflation is higher.
Fisher Hypothesis
• rnom = rreal + E(i), E(i) is the expected inflation for next period.

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Taxes and the Real Rate of Interest

• Taxes are based on nominal income and tax brackets. To address “bracket creep” caused by
inflation, United States Congress mandated index-linked tax brackets in the Tax Reform Act
of 1986. (Taxes in HK is much simplier)
• Despite this, inflation still affects the taxation of savings.
• Given a tax rate t and nominal interest rate rnom , the after-tax nominal interest rate is
rnom (1 ´ t).
• The real after-tax interest rate is approximately the after-tax nominal rate minus the inflation
rate i:
rnom (1 ´ t) ´ i = (rreal + i)(1 ´ t) ´ i = rreal (1 ´ t) ´ it
Example:
You are in a 30% tax bracket. Nominal return is 12%, and inflation is 8%. Before-tax real
rate: 4% (since 12% - 8% = 4%).
Ideally, after-tax real return: 4% ˆ (1 ´ 0.3) = 2.8%.
However, the tax code does not separate inflation compensation.
After-tax nominal return: 12% ˆ (1 ´ 0.3) = 8.4%.
After-tax real interest rate: 8.4% ´ 8% = 0.4%.
Real after-tax return drops by it = 8% ˆ 0.3 = 2.4%.

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Effective Annual Rate and Annual Percentage Rate

• The Effective Annual Rate (EAR) is the actual interest rate that an investor earns or pays in a
year after accounting for compounding interest. It provides a true representation of the cost
of borrowing or the return on investment when interest is compounded more than once a year.
[ ]1/T
EAR = 1 + rf (T) ´1
100
where rf (T) is the total return over a holding period of length T, rf (T) = P(T) ´ 1 for
Zero-Coupon bonds.
• The Annual Percentage Rate (APR) is the yearly interest rate charged on a loan or earned
through an investment, expressed as a percentage. It does not account for the effects of
compounding within the year.
• Generally, if there are n compounding periods in a year, and the per-period rate is rf (T), then
the APR = n ˆ rf (T)
EAR = [1 + T ˆ APR]1/T ´ 1
Equivalently,
(1 + EAR)T ´ 1
APR =
T

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Interest Rate Types

There are several types of interest rate with different calculation methods: some are used in
financial contracts for cashflow calculation, while others, e.g. the continuous interest rate, is
used for derivatives pricing purposes.
Denote
• M: initial amount
• MT : money amount after T years
1) Simple interest rate (rm ):
MT = M(1 + rm T)
In money market, the interest-bearing instruments (e.g. bank deposit, certificate of deposit,
etc.) use this type of interest rate. Hence, it is also referred to as money market rate.
A non-interest-bearing instrument such as a treasury bill and a commercial paper is quoted in
price for receiving a fixed amount at maturity. The implied rate measuring the discount is
called discount rate (rd ):
M = MT (1 ´ rd T)
2) Compound rate:
MT = M(1 + r)T

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Interest Rate Types - Cont

3) Continuous Rate
It is used in continuous time modelling as a compound rate applied to infinitesimal time
intervals ∆t.
1 1
MT = lim M(1 + r∆t)T/∆t = lim M(1 + )nˆrT = MerT , where n =
∆tÑ0 nÑ+∞ n r∆t
Alternatively, we can assume the differential equation

dMt = rMt dt
More generally, the instantaneous interest rate is defined as rt such that

dMt = rt Mt dt
The resolution is
şT
MT = Me 0 rs ds

If r is constant, then

MT = MerT .

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Relationship Between Different Types of Interest Rate

One can easily transform rates of different types through the equivalence in cash-flows.
For instance, the continuous rate r is not directly observable from the financial instruments in
the market. However, r can be derived from the money market rate rm :

ln(1 + rm Tm )
1 + rm Tm = erT or, equivalently, r =
T

where Tm is the day count fractions under the day count convention of the money market
instrument while T usually follows ACT/365 or ACT/ACT.
Due to the interchangeability of the interest rate types, we are indifferent regarding the
choice of the type rate to be in financial calculation.

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