What Are Interest Rates? Types and Meaning

Date Modified: 28/03/2024

Interest rates are a concept that every trader and consumer should know, as they can have a direct impact on prices, markets, and trading.

In this comprehensive article, you will learn about interest rates, how you can trade them, and the different types of interest rates.

What are interest rates

What Is an Interest Rate?

Interest rates vary depending on your position. If you’re a borrower, interest refers to the percentage of money you need to pay for a loan. On the other hand, if you’re saving money, interest rates represent the amount you earn on your savings.

TL;DR

  • Interest rate is the amount of money paid by borrowers or earned on an investment.
  • There are multiple types of interest rates and the main ones include simple, compound, effective, fixed, accrued, real, and effective interests.
  • Interest rates can be traded using interest rate Futures contracts.

Types of Interest Rate Markets

There’s a wide variety of interest rates to familiarize yourself with, and the main types are as follows:

Simple Interest

This is the most basic type of interest and it comprises the amount of money owed without including factors like inflation. It is also known as “regular” or “nominal” interest. However, it is considered rare, as various factors can eventually intervene and affect the calculation.

Simple interest rate formula

Compound Interest

This refers to the amount of money one gets from their earnings.It is called “interest on interest,” and is usually more prevalent on loans.

Compound Interest Rate formula

Effective Interest

This refers to the amount paid on a loan following adjustment for compounding over time.

Effective Interest Rate Formula

Accrued Interest

This pertains to the accumulated amount of money over a specific time frame that must be paid. Additionally, this also denotes the sum of bond interest that has been gathered since the most recent bond interest payment.

Accrued Interest Rate Formula

Real Interest

This refers to the amount paid by the borrower or earned for savings after considering inflation.

Real Interest Rate Formula

Fixed Interest

This type of interest is “fixed” or “stable” as it doesn’t change throughout the lifetime of the loan.

Variable Interest

This interest changes or “varies” over time based on various factors and derives its value from a benchmark interest rate that changes periodically.

What Is the Difference Between Interest Rates and Yields?

Interest rates and yields may sometimes get intertwined and confused with one another given their similarities.

However, these are two different financial derivatives. Interest rates represent the amount paid by the borrower or the amount that should be paid for an investment, while yields are the return on investment or the total amount of money earned from an investment, including interest.

The Importance of Interest Rates

Interest rates are important in light of the fact that they have a direct impact on the economy and financial markets. They affect borrowing costs, with lower rates yielding more interest in mortgages or purchases, while higher rates may lead to spending restrictions.

Moreover, interest rates directly influence spending habits, economic expansion or contraction, and the success or failure of specific markets or industries. For example, higher interest rates usually lead to drops in tech stocks but can have a positive effect on safe-haven assets such as growth or defense stocks.

Additionally, higher rates may be beneficial for banks and finance companies as they can ask for more money for lending.

What Is Interest Rate Trading?

Many may want to potentially take advantage of interest rates by trading interest rate derivatives. Interest rate trading involves buying and selling interest rate derivatives depending on whether you think they will rise or fall. For instance, if you believe interest rates will rise, you may open a buy position on the rate derivative, while if you think they will fall, you might open a sell position.

How to Trade Interest Rates

Interest rate trading can be done in a plethora of ways. One of the most common ways to trade interest rates is through Futures contracts with Futures providers like Plus500 .

Interest rate Futures are a type of Futures contracts that provide traders with exposure to interest rate changes. Futures contracts are traded on American exchanges like the CME, and CBOT and obligate their traders to either buy or sell the Futures at a predetermined time and price in the future.

In order to get a better idea on interest rates trading, read our article on “How to trade interest rates”. To get a better understanding of how Futures contracts function, you can read our article on " What Are Futures and How to Trade Them".

Understanding Interest Rate Futures

Advantages and Risks of Interest Rate Futures

Some advantages of interest rate Futures include their use for hedging against adverse price swings, transparent pricing, cost-effectiveness due to the absence of security transaction taxes, and high liquidity.

However, interest rate Futures can be volatile as their prices swing and can be affected by uncontrollable events.

Interest Rate Futures Trading Strategies

When trading interest rate Futures, traders speculate on whether interest rates go up or down in the future and they can do so by using a variety of trading strategies.

This can range from using technical analysis, which employs past price patterns to identify potential entry and exit points. In addition, traders may refer to indicators such as central bank policies, and inflation data like CPI and PCE to see how these might affect interest rate prices and base their decisions accordingly.

They may also employ fundamental analysis, which looks at benchmark rates’ intrinsic value as they assess economic health.

You can read more about the different types of trading strategies in our article on “Fundamental Analysis vs. Technical Analysis.”

Conclusion

In conclusion, interest rates are crucial for traders and consumers, impacting borrowing costs, investment returns, and economic health.

Different types of interest rates play vital roles in financial transactions, and a thorough understanding of interest rate dynamics is essential for success in this influential financial arena.

FAQs About Interest Rates

How are interest rate Futures used for hedging?

Interest rate Futures can indeed be used for hedging as they allow traders to counteract potential gains or losses resulting from the benchmark rates’ fluctuations.

Are there other ways to trade on interest rate changes?

Besides interest rate Futures, one way to potentially benefit from interest rates is through trading interest rate Options. Alternatively, bonds tend to perform better when rates are lower and vice-versa.

How do you price interest rate Futures?

Interest rate Futures are priced based on the underlying index.