7/14/2015

Interest Rates:
APR and EAR
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania

CopyrightMichaelR.Roberts

Last Time
Time Value of Money
Intuition, tools and discounting
Compounding
Useful shortcuts
Taxes
Inflation
CopyrightMichaelR.Roberts

7/14/2015

This Time
Interest Rates
Interest rate quotes
Non-annual cash flows and
compounding

CopyrightMichaelR.Roberts

APR & EAR

CopyrightMichaelR.Roberts

7/14/2015

Current 5-Year Jumbo CD Rates

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

Difference between
Rate and APY?

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

7/14/2015

Current 5-Year Jumbo CD Rates

Rate = APR or Annual
Percentage Rate

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

Rate = APR or Annual
Percentage Rate
Measures amount of
simple interest earned
in a year

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

7/14/2015

Current 5-Year Jumbo CD Rates

Rate = APR or Annual
Percentage Rate
Simple interest =
interest earned
without compounding

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

Rate = APR or Annual
Percentage Rate
Many bank quotes are
in terms of APR

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

7/14/2015

Current 5-Year Jumbo CD Rates

Rate = APR or Annual
Percentage Rate
APR typically not
what we earn or pay

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

APY = Annual
Percentage Yield

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

7/14/2015

Current 5-Year Jumbo CD Rates

APY = EAR or
Effective Annual Rate

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

APY = EAR or
Effective Annual Rate
EAR measures actual
amount of interest
earned/paid in year

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

7/14/2015

HOW ARE DIFFERENT

RATES RELATED?

CopyrightMichaelR.Roberts

Lesson: EAR is a discount rate

EAR is what matters for computing
interest and discounting cash flows

CopyrightMichaelR.Roberts

7/14/2015

Lesson: APR is not a discount rate.

APR is a means to an end. We use it
to get a discount rate (e.g., EAR)

CopyrightMichaelR.Roberts

How do we get from an APR to an

EAR (and vice versa)?

CopyrightMichaelR.Roberts

7/14/2015

Lesson: The relation between APR

and EAR is:

CopyrightMichaelR.Roberts

Lesson: The relation between APR

and EAR is:

k is the number of
compounding periods
per year

CopyrightMichaelR.Roberts

10

7/14/2015

Lesson: The relation between APR

and EAR is:

i is the periodic interest rate, or

periodic discount rate
CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?

CopyrightMichaelR.Roberts

11

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0

100

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
k=2
Period
0
100

2
?

CopyrightMichaelR.Roberts

12

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year? Period 1
Period 2
(n = 1)
Period
0

(n = 2)
1

100

2
?

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0
100

2
?

CopyrightMichaelR.Roberts

13

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0

100

?
Earn 2.5% interest

Earn 2.5% interest

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0
100
100 x

102.5

(1+0.025)1

CopyrightMichaelR.Roberts

14

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0

100
100 x (1+0.025)1

105.0625
102.5
102.5 x (1+0.025)1

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Period
0

100
100 x

(1+0.025)1

105.0625
102.5
102.5 x (1+0.025)1

CopyrightMichaelR.Roberts

15

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Year
0

100

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Year
0
100

0.5

1
?

CopyrightMichaelR.Roberts

16

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Year
0

0.5

100

1
?

CopyrightMichaelR.Roberts

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Year
0

0.5

100

1
105.0625

Earn 5.0625% interest

CopyrightMichaelR.Roberts

17

7/14/2015

Example
Invest $100 in CD offering 5% APR
with semi-annual compounding. How
much money will you have in one
year?
Year
0

0.5

100

1
105.0625

Earn 5.0625% interest

CopyrightMichaelR.Roberts

Lesson: If you discount cash flows

using EAR, then measure time in
years. If you discount cash flows using
periodic interest rate, then measure
time in periods.

CopyrightMichaelR.Roberts

18

7/14/2015

Proof

where N = kT = # of periods

CopyrightMichaelR.Roberts

Periods vs Years
Periods
0

100

102.5
100 x (1+0.025)

2
105.0625
102.5 x (1+0.025)

CopyrightMichaelR.Roberts

19

7/14/2015

Periods vs Years
Periods
0

100

102.5

2
105.0625
102.5 x (1+0.025)

100 x (1+0.025)

Years
0
100

0.5

102.5
105.0625
100 x (1+0.050625)1/2 102.5 x (1+0.050625)1/2

CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

APR = 2.37%

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

20

7/14/2015

Current 5-Year Jumbo CD Rates

APR = 2.37%
k = 365 (or 360, 252)

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

Current 5-Year Jumbo CD Rates

APR = 2.37%
k = 365 (or 360, 252)
i = 2.37% / 365
= 0.006714%

*Bankrate.com as of 12/16/2014
CopyrightMichaelR.Roberts

21

7/14/2015

Current 5-Year Jumbo CD Rates

APR = 2.37%
k = 365 (or 360, 252)
i = 2.37% / 365
= 0.006714%

*Bankrate.com as of 12/16/2014

EAR =
(1+0.006714%)365-1
= 2.398%

CopyrightMichaelR.Roberts

Summary

CopyrightMichaelR.Roberts

22

7/14/2015

Lessons
EAR is a discount rate
Measures cash flows in years

Period interest rate, i, is a discount rate

Measures cash flows in periods

APR is not a discount rate

CopyrightMichaelR.Roberts

Lessons
Moving between EAR and APR

where
i = APR / k and k = # of periods per year

CopyrightMichaelR.Roberts

23

7/14/2015

Coming up next
Interest Rates
Term Structure of interest rates and the
yield curve

CopyrightMichaelR.Roberts

24