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An interest rate is economically composed of different components designed to compensate lenders (investors) for their investment. The base component is a risk-free rate, or the amount a lender would charge if there was no possibility of default. Another component is a credit spread, which compensates the lender for the possibility that the borrower may default and fail to repay its loan. The interest rate demanded by the market may also include components for the liquidity risk of the instrument, other market considerations, and contractual features, such as prepayment options. In practice, the individual elements that compose the interest rate demanded by the market may be difficult to quantify.
Interest, in its simplest form, is calculated by applying a contractually-specified rate of return to the principal (par) amount of a receivable (investment) that has specified payment dates and a stated maturity date. The amount of interest earned can be impacted by other factors, such as whether a receivable was acquired at an amount less than its principal amount (a discount) or more than its principal amount (a premium).
Figure LI 6-1 describes some of the more common types of interest rates.
Figure LI 6-1
Types of interest rates
Interest type
Description
Fixed-rate interest
Interest rates set at issuance of the financial asset that do not change over time
Variable-rate interest
Interest rates that change over time, most often based on a published interest rate index, such as the London InterBank Offered Rate (LIBOR), Secured Overnight Financing Rate (SOFR) or a prime rate
Zero coupon
A zero-coupon bond is purchased for an amount lower than its face value, with the face value repaid at maturity.
There is no stated interest rate and the issuer does not make periodic interest payments. When the bond reaches maturity, its investor receives the face (or par) value. Although there are no regularly scheduled interest payments, interest is earned over time as the difference between the bond’s purchase price and its par value.
Paid-in-kind (PIK)
Interest on a financial asset paid by the issuance of a new bond as compensation for interest due, which in turn has its own stated terms, including interest, principal, and maturity.
Interest can be simple or compounded. Simple interest is computed on the amount of the principal only; compound interest is computed on principal and on any interest earned that has not been paid.
When the terms of a financial asset involve returns that vary in timing or amounts, the financial asset should be evaluated to determine if there are any freestanding or embedded derivatives that should be accounted for separately. See PwC's Derivative instruments and hedging activities guide (DH 4) for guidance on the evaluation of embedded features.
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