Whether a given rate of interest represents good value or not may depend on the rate of inflation. Economists talk of the real rate of interest, that is, the nominal rate of interest, minus the rate of inflation.
In the UK in 1989/90, interest rates reached 15% while the government desperately tried to curb inflation, which had reached 11%. In 1992, the rate of interest have fallen to 10% but inflation had risen to less than 4%. Thus, although nominal rates had fallen from 15% to 10%, the real rate had risen from 4% to 6%. In 2002, with nominal rates of 4% and inflation at 2.5%, real rates are at a new low of 1.1%.
Yield is arguably the most important term in the financial markets. Yield is the return to the investor expressed as an annual percentage. As the markets are all about raising capital, the yield is crucially important. Unfortunately it’s not as easy as it seems.
Supposed , we have a bond issued in 1996 and maturing in 25 years-2021. The bond pays a rate of interest of 10% once per year. What is the yield? At first, the answer seems obvious-10%. If I buy the bond, you argue, I get 10%-where’s the problem? The problem is that your answer is only true if you paid full price for the bond.
Bonds have a par or nominal value. This is taken to be $1000, £100, etc. This is the amount, which the rate of interest is based and the amount which will be repaid at maturity. You buy the 25 year 10% bond and pay the par value of thousand dollars. Your yield is 10%. However, as secondary market trading begins, investors may pay you more or less than $1000 for the bond with a par value per thousand dollars-this affects the yield. The price of the bond is expressed as a percentage of the par value. For example, if the price is 90, the price for $1000 par value is $900.
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