Nominal interest rate

Definition

The nominal interest rate is the stated interest rate on a loan or investment, not adjusted for inflation. It represents the percentage increase in money that a borrower pays to a lender or an investor earns on an investment over a specified period. This rate is crucial in understanding how fixed income securities yield returns and how it relates to the term structure of interest rates, which shows the relationship between interest rates and different maturities of debt.

5 Must Know Facts For Your Next Test

1. The nominal interest rate does not account for inflation, meaning that it can misrepresent the actual purchasing power of the returns from investments.
2. Fixed income securities typically pay a nominal interest rate, which investors receive as periodic coupon payments.
3. Changes in nominal interest rates can affect the prices of existing bonds; when rates rise, bond prices typically fall and vice versa.
4. The term structure of interest rates can illustrate how nominal interest rates vary across different maturities, showing the market's expectations for future economic conditions.
5. Nominal interest rates can be influenced by various factors, including central bank policies, economic growth forecasts, and changes in inflation expectations.

Review Questions

• How does the nominal interest rate impact the attractiveness of fixed income securities for investors?
  • The nominal interest rate directly influences the cash flows that investors receive from fixed income securities. Higher nominal interest rates make these securities more attractive because they offer greater periodic coupon payments. Conversely, when nominal rates are low, fixed income investments may seem less appealing compared to other investment opportunities that might offer higher returns.
• Discuss how shifts in nominal interest rates can affect the term structure of interest rates and what implications this has for borrowers and lenders.
  • Shifts in nominal interest rates can lead to changes in the shape of the term structure of interest rates. For instance, if nominal rates rise sharply, this may flatten or invert the curve, indicating that short-term borrowing becomes more expensive relative to long-term borrowing. This impacts borrowers who may find it costlier to take out loans in a rising rate environment while lenders adjust their expectations regarding future interest income based on changing market conditions.
• Evaluate the relationship between nominal interest rates and real interest rates, and analyze how this relationship affects investment decisions.
  • Nominal interest rates represent the stated return on investments, while real interest rates provide insight into the purchasing power of those returns by adjusting for inflation. When making investment decisions, investors must consider both rates; if nominal rates are high but inflation is even higher, the real return could be negligible or negative. This relationship influences whether investors choose fixed income securities or look for alternative investments that might provide better real returns in different economic climates.

Related terms

real interest rate:

The real interest rate is the nominal interest rate adjusted for inflation, reflecting the true cost of borrowing and the true yield on an investment.

yield to maturity: Yield to maturity is the total return anticipated on a bond if held until it matures, taking into account all coupon payments and the face value at maturity.

interest rate risk:

Interest rate risk refers to the potential for investment losses that result from a change in interest rates, which can affect the price of fixed income securities.