Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 2

Mathematics of Finance

Interest Rates

Interest on money borrowed and lent is a feature of our daily lives. Most people have paid and received interest at some point in time. It is a common practice to make investments by buying bonds and debentures and by opening checking, savings, and time deposits with institutions such as commercial banks. Bonds and debentures pay interest on their face value or principal. We refer to this as the coupon. Banks, although they do not pay interest on checking accounts, pay interest on savings as well as time deposits.

In today's consumer-driven economy, it is also a common practice to buy products and services on loan. Borrowing to buy residential property, which is referred to as a mortgage loan, is a major component of debt taken by individuals and families. People also borrow in the form of student loans to fund their academic pursuits. Retail borrowing to finance various purchases such as automobiles and consumer durables (white goods) is a feature of today's society.

Interest may be construed as the compensation that a lender of capital receives. Why should a lender charge for making a loan? In other words, why not give an interest-free loan? Remember: If you part with your money in order to extend a loan, you are deprived of an opportunity to use the funds while it is on loan. The interest you charge is consequently a compensation for this lost opportunity. In economic parlance, we would term this as rent. Capital, like land and ...