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 .
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