Concept
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All of these different types of rates may seem like an overwhelming list of formulae. Instead of attempting to memorize them, one should try to absorb the rationale behind each formula, and the different approaches taken because of their respective rationale.
In fact, there are really two main approach choices: interest-rate versus discount rate, and compound-rate vs simple-rate. If you understand these two choices, and the differences that either choice gives rise to, the formulae become much more manageable.
It is essential to consider and understand how these different types of interest rates can be used. None of what we have discussed can be used to deduce a suitable price for a money-market instrument — we are not valuing instruments in this sense (sometimes called a fundamental valuation).
Instead, what these interest rate conventions allow you to do is take an interest rate and, when we know how to apply it accurately, calculate a suitable price — the price comes from the interest rate, not out of thin air.
This can still be very useful for a host of reasons. The main reason is that — given the efficiency of the market – one can usually find the market-going interest rate. The money market prices all similar instruments so that they have the same interest rates. If interest rates are at 5% (due to some interest-rate convention), you can determine the market-related price of any given bill or note with one of the above formulae. If you are considering depositing your money, you can compare the available interest rate with the market one to determine whether you are getting good deal.
There are two important caveats — both explored in the next module — to this principle of a market-going interest rate. First, interest rates do tend to vary with the term of the underlying loan, so the interest rate used for a 3-month loan is not necessarily suitable to apply to a one-year loan (this idea is known as the term structure of interest rates). For example, the interest rate on a call deposit is different to that on a term deposit. Second, we have discussed how the possible default of a borrower is reflected by a higher interest rate, and so it is not necessarily appropriate to apply the same interest rate to instruments issued by different entities. The market interest rate is often understood to refer to instruments without material default risk (such as treasury bills), which we will expand upon in later modules.