Series 3: 6.1.6. Interest Rate Fundamentals

6.1.6. Interest Rate Fundamentals

If interest rates are the cost of money, interest rate analysis requires the trader to understand current trends in the supply and demand of money. As a medium of exchange, of course, money penetrates every aspect of a national economy. Interest rate analysis, therefore, requires knowledge, not only of the performance of the overall economy, but also the likely response of the federal government to manage it.

Before getting started, let’s break down the elements of an interest rate into its component parts. Nominal interest rates are the actual interest rates you pay or receive on an investment without adjusting for inflation. The nominal rate is composed of a real interest rate and inflation. Assume the nominal interest rate is 4% and the inflation rate is 1.5%. Then the real interest rate must be 2.5%. The real interest rate is defined as the compensation an investor expects to pay (receive) for borrowing (or lending) money after adjusting for inflation. The real interest rate is composed of two components: a