Study guide
1.8 Interest Rates
Securities Industry Essentials SIE
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1 Introduction
About the SIE Exam How to Use This Course
2 Chapter 1: Knowledge of Capital Markets
1.1 Regulatory Bodies 1.2 State Regulation 1.3 Market Participants 1.4 Types of Markets 1.5 The Exchanges 1.6 OTC Markets 1.7 Economic Policies 1.8 Interest Rates 1.9 Business Cycles 1.10 International Economics
3 Chapter 2: Understanding Products and Their Risks
2.1 Common Stock Basics 2.2 Corporate Actions 2.3 Preferred Stock 2.4 ADRs 2.5 Bond Basics 2.6 Yields 2.7 U.S. Treasury Securities 2.8 Corporate Bonds 2.9 Municipal Bonds 2.10 Money Market Instruments 2.11 Options Basics 2.12 Hedging Strategies 2.13 Mutual Funds 101 2.14 Mutual Fund Fees 2.15 ETFs 2.16 UITs & REITs 2.17 DPPs 2.18 Systematic Risk 2.19 Non-Systematic Risk 2.20 Mitigation Strategies
4 Chapter 3: Trading, Customer Accounts and Prohibited Activities
3.1 Order Types 3.2 Trade Settlement 3.3 Quoting 3.4 Account Types 3.5 Account Registration 3.6 Retirement Plans 3.7 Education Savings 3.8 AML Rules 3.9 Market Manipulation 3.10 Insider Trading 3.11 Customer Protection
5 Chapter 4: Overview of Regulatory Framework
4.1 Registration 4.2 Continuing Education 4.3 Employee Conduct 4.4 Correspondence
1.8 Interest Rates
Key Takeaways Explain This Topic AI
Bond prices and interest rates move in opposite directions: rising rates cause existing bond prices to fall
Duration measures a bond's sensitivity to rate changes: a 5-year duration bond changes approximately 5% in price per 1% rate change
An inverted yield curve (short-term rates exceeding long-term rates) has historically preceded most U.S. recessions
Real interest rate equals nominal rate minus inflation, representing the true purchasing power growth of an investment
The prime rate typically equals the federal funds rate plus 3%, serving as a benchmark for consumer and business lending rates
Last updated: January 2026
Interest rates are the price of borrowing money — and they're one of the most important factors affecting securities prices. Understanding how rates work and how they impact investments is crucial for the SIE exam.
What Are Interest Rates?
An interest rate is the cost of borrowing money, expressed as a percentage of the principal. It's also the return earned by lenders for providing funds.
Key Interest Rates
- Rate What It Is Set By
- Federal Funds Rate Rate banks charge each other overnight Federal Reserve (target)
- Prime Rate Rate banks charge their best customers Banks (follows fed funds)
- Discount Rate Rate Fed charges banks for emergency loans Federal Reserve
- Treasury Rates Yields on U.S. government securities Market forces
- The Federal Funds Rate
The federal funds rate is the benchmark for short-term interest rates in the U.S. economy. The Fed sets a target range, and banks trade reserves to stay within it.
- How It Influences Other Rates
- Fed sets federal funds target
- Prime rate typically = Fed funds + 3%
- Other rates adjust accordingly
- Eventually affects mortgages, car loans, credit cards, and business loans
- Example Rate Chain
If Fed funds target is 5.25-5.50% :
- Prime rate ≈ 8.50%
- Credit cards ≈ Prime + 10-15%
- Mortgages influenced by longer-term Treasury rates
- Interest Rates and Bond Prices
This is one of the most important relationships in finance:
Bond prices and interest rates move in opposite directions.
Why the Inverse Relationship?
When interest rates rise:
- New bonds are issued with higher coupon rates
- Existing bonds (with lower coupons) become less attractive
- Existing bond prices must fall to offer competitive yields
When interest rates fall:
- New bonds are issued with lower coupon rates
- Existing bonds (with higher coupons) become more attractive
- Existing bond prices rise
- Example
You own a bond paying 4% interest. If new bonds start paying 5%:
Who would pay full price for your 4% bond?
- Your bond's price must drop until its yield matches 5%
- Duration: Measuring Rate Sensitivity
Duration measures how sensitive a bond's price is to interest rate changes.
- Duration Rate Sensitivity
- Short duration (1-3 years) Less sensitive
- Intermediate duration (4-7 years) Moderate sensitivity
- Long duration (10+ years) Most sensitive
- Rule of Thumb
For every 1% change in interest rates, a bond's price changes approximately equal to its duration:
- 5-year duration bond → ~5% price change per 1% rate change
- 10-year duration bond → ~10% price change per 1% rate change
- The Yield Curve
The yield curve plots interest rates across different maturities, typically using Treasury securities.
Types of Yield Curves
- Shape Description Economic Signal
- Normal (Upward) Long-term rates > short-term rates Economic growth expected
- Flat Rates similar across maturities Uncertainty or transition
- Inverted Short-term rates > long-term rates Potential recession ahead
- Why It Matters
- Normal curve : Investors demand higher rates for longer commitments (time value of money)
- Inverted curve : Investors expect future rates to fall (often preceding recessions)
- Historically : Inverted yield curves have preceded most U.S. recessions
- Real vs. Nominal Interest Rates
- Type Definition Formula
- Nominal rate The stated rate What you see quoted
- Real rate Rate adjusted for inflation Nominal rate - Inflation
- Example
If your bond pays 5% (nominal) and inflation is 3%:
- Real return = 5% - 3% = 2%
- Your purchasing power only grows 2%
- Why Real Rates Matter
- Investors care about purchasing power, not just dollars
- Negative real rates (inflation > nominal rate) erode wealth
- Real rates influence investment decisions
- Interest Rates and Stock Prices
Interest rates affect stocks through multiple channels:
- Channel How Higher Rates Affect Stocks
- Borrowing costs Companies pay more to borrow → Lower profits
- Consumer spending Higher mortgage/loan payments → Less spending
- Valuation Future earnings worth less (higher discount rate)
- Competition Bonds become more attractive vs. stocks
- Sector Sensitivity
- Sector Rate Sensitivity Why
- Utilities High Compete with bonds for yield investors
- Real Estate High Higher mortgage costs hurt demand
- Banks Moderate benefit Earn more on loans (but borrowers may default)
- Technology High Future earnings heavily discounted
- Inflation and Interest Rates
Inflation and interest rates are closely linked:
- The Relationship
- High inflation → Fed raises rates to cool economy
- Low inflation → Fed can lower rates to stimulate growth
- Deflation → Rates may go to zero or negative
- Inflation Expectations
Bond yields incorporate expected inflation:
- If investors expect 3% inflation, they demand at least 3% yield
- Real yield = Nominal yield - Expected inflation
- Interest Rate Risk
Interest rate risk is the risk that changes in rates will affect investment values.
Who Faces Interest Rate Risk?
- Investor Type Concern
- Bondholders Rising rates hurt existing bond values
- Stock investors Rate changes affect valuations
- Banks Mismatch between deposit rates and loan rates
- Borrowers Variable rate loans become more expensive
- Managing Interest Rate Risk
- Shorter duration bonds — Less price volatility
- Floating rate securities — Rates adjust with market
- Laddering — Spread maturities across time
- Diversification — Mix of rate-sensitive and less-sensitive investments
- Key Takeaways
- Interest rates are the price of borrowing money
- Bond prices move inversely to interest rates
- Duration measures a bond's sensitivity to rate changes
- The yield curve shows rates across different maturities
- An inverted yield curve often signals recession ahead
- Real interest rates account for inflation
- Interest rates affect both stocks and bonds , often in opposite ways