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Financial context of business – I

Interest rates

5.1 A central rate of interest

 The rate at which the central bank lends to the money market, based on the
treasury bill rates.

 Lenders would then adapt this to incorporate risk and maturity.

 Lenders in the financial markets normally demand higher interest rates on loans
as the term (i.e. length of time) to maturity increases

5.2 Real and nominal interest rates

 The interest rate used to calculate cash flows is known as a “money rate” or
“nominal rate”. This is effectively the lender’s required return and incorporates
risk, maturity and inflation.

 The “real” interest rate is the return/cost after inflation has been taken out.

 1 + m = (1 + r)(1 + i)

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