Interest Rates

This chapter examines different conventions when returns or interest rates are ‘annualised’ – namely ‘simple interest’, ‘compound interest’ and ‘continuously compounded interest’. It shows how a Forward Rate Agreement is priced. The chapter provides an overview of the key interest rates used in the market and different day-count and interest rate conventions used when calculating ‘annual yields’. London Interbank Offer Rate is an unsecured loan and borrowing is for maturities of one day to one year. The Fed Funds rate is the rate at which US banks lend to each other, overnight. The most common type of Repurchase Agreement (repo) is an overnight repo, which can be rolled over each day. The overnight index swap (OIS) rate is also very close to being a risk-free rate. There is a term structure of OIS rates, so a zero-curve can be used to determine a set of ‘risk-free’ rates that can be used in derivatives pricing.