Suppose a 18 months Spot Rate is at 9%. Why is not that the one year rate is 6%? I mean what does the 18 months stand for after all?
Then I come across the term BEY. While some tell me it is equal to a year and others take it as being for 6 months? Which is which?
Often when we use the Spot Rates I see it being converted to 6 months, I think it is because generally they are semi annual payments. How do we actually work all these? I have so many questions that I don’t even know what to expect!
Hope you can help me!
Interest rates are always – _ always! _ – quoted annually.
When you’re given an 18-month spot rate of 9%, that means 9% _ per year _, and that that discount rate applies to a (single) cash flow that comes 18 months in the future. It’s not that the one year (12-month spot) rate is 6% because that spot rate doesn’t apply to a cash flow that comes in 12 months; it applies to a cash flow that comes in 18 months. The 12-month spot rate can be anything.
If a rate is quoted as BEY, then it is an annual rate (rates are _ always _ annual), computed as twice the semiannual effective rate. Thus, BEY is a nominal (annual) rate, compounded twice per year.
Virtually all rates applied to bonds are quoted as BEY. Thus, they have to be converted to 6-month rates (by dividing the annual rate by 2) to arrive at an effective rate that can be compounded. Only effective rates can be compounded.
I wrote an article on nominal vs. effective rates that may be of some help: http://financialexamhelp123.com/nominal-vs-effective-interest-rates/.