## Tuesday, December 27, 2016

### What is the Difference Between Rate of Interest and Rate of Return?

Interest Rate:
Interest rate is the promised or specified or coupon rate of interest payable on the principal amount of the loan or the nominal value of the instrument like a bond or a fixed deposit.

For example let us consider the following picture of 9% Treasury note of the US:
 Picture of 9% US Treasury Note indicating the nominal value and rate of interest
In this example:
• The principal or nominal value of the instrument is US\$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US\$ 90

Rate of Return:
Rate of return is the actual rate actually obtained or earned by the investor on the investment.
Can there be a difference between interest paid and actually earned by the investor? How is it possible?
Yes, indeed it is possible.
How?
Because there is what is called a secondary market for bonds, treasury notes and various other kinds of debt instruments, where these are sold at prices different from the nominal value.
For example the “9% US\$ 1000 Treasury Note” can be trading at either US\$1100 or US\$ 800 depending on the market demand and supply. Let us examine two situations where the note is bought at US\$ 1100 and 800.
Bought at US\$ 1100:
• The principal or nominal value of the instrument is US\$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US\$ 90
• Actual cost of investment is US\$ 1100
• Interest rate actually obtained or earned by the investor is (US\$ 90/ 1100)*100 = 8.18%
• Rate of Return therefore is 8.18% and not 9%

Bought at US\$ 800:
• The principal or nominal value of the instrument is US\$ 1000
• The coupon rate or rate of interest is 9%
• The annual interest receivable is US\$ 90
• Actual cost of investment is US\$ 800
• Interest rate actually obtained or earned by the investor is (US\$ 90/ 800)*100 = 11.25%
• Rate of Return therefore is 11.25% and not 9%
• This rate of return actually obtained is also called the yield .