An interest rate is a time-specific payment demanded of a borrower by a lender for the use of some asset.
Interest Rate Example
Suppose that a consumer borrows $1,000 from a bank, and the bank demands that the borrower pay back the $1,000 loan plus a $60 interest payment at the end of one year. The interest rate in this example would be 6% per year.
Interest Rates in Finance
Interest rates are absolutely central to the functioning of a modern capitalist economy.
For a modern economy to work, people must be able to lend and borrow virtually every good and service produced with some means of compensating the lender for the time and risk involved in foregoing an instant exchange of value.
That is why there are different interest rates for virtually every situation involving a borrower and a lender, from government bonds to consumer financing.
The interest rate charged will depend on a number of factors, including the willingness of each party to the transaction, the creditworthiness of the borrower and the external risks to the transaction.
Most interest rates are ultimately set as a premium to the overnight inter-bank lending rate, which is generally the lowest interest rate available in an economy at any point in time.
Lenders then add a premium to this base rate depending on the relevant factors to the specific transaction taking place.
Interest Rates in Trading
Day traders will deal with interest rates on a daily basis in a number of different scenarios.
Brokers will charge interest based on a relatively high annual rate for any margin lending facility employed by the day trader. The day trader may also receive a comparatively low annual rate on any capital that is idle in their brokerage account.
Day traders who trade in bonds will need to follow interest rates closely for a range of securities, as bond prices are affected by the direct interest rate for the bonds in question and the interest rate for related bonds. Note: bond price and interest rates have an inverse relationship.
Interest rates can also have a major impact on equity prices, both as they affect the capacity of a company to invest generally and the impact they have on the overall economic climate.
Many financial companies are also directly exposed to changing interest rates, as they generate revenue from borrowing and lending, or acting as intermediaries in the process.
Currencies are heavily influenced by the main interest rate set in their country by the central banking authorities. Interest rate decisions or commentary relevant to interest rates by officials can dramatically impact currency pairs.
Interest rates are central to both modern capitalist economies and trading as a whole.
Day traders should be comfortable with the basic concepts involved in interest rates and how the various interest rates in the market are determined, as well as understanding the events that will influence them in the future.
Day traders should also be familiar with how various interest rates will impact the price action of the securities that they trade in.