Short Term Interest Rates

Interest rates on fixed-income assets with a maturity of less than one year

Short-Term Interest Rates or STIRs are interest rates on fixed-income assets with a maturity of less than one year. They are a sub-category of interest rates. This should not be confused with long-term interest rates. 

Short Term Interest Rates

Interest rates are split into short-term and long-term interest rates. The key difference is the time to maturityMaturity is the time taken for the loan to be paid back. Generally, STIRs are payable within one year and use an average of daily rates measured in percentage terms.

The rates themselves are based on the daily rates within a one to three-month period. These types of rates are also known as the "money market rate" or the "treasury bill rate."

Individuals use short-term rates to gain liquidity for the near future. Loans can quickly be handed out and given to people who need to make payments as soon as possible. 

For example 
Loaning a friend £100 to make a monthly rent payment is an example of a short-term loan. You are promised to be paid the money back by the end of the week.

However, if the friend is in dire straits, you may need to make a long-term loan of £100 with only a promise of being paid back in a few years. This is because they simply lack access to cash to be able to pay you back. 

For a friend who needs to pay rent quickly, these rates are very useful. The interest may not compile as compared to traditional loans if paid back on time.

There are multiple advantages to using short-term rates. The first is one alluded to previously. There is great flexibility when it comes to access to short-term loans. One can commit only in the near future to a loan that one may need when cash is tight. 

If you know that financially things will turn around, then short-term loans are extremely useful for looming payments before that point. You also do not need to worry (for the most part) about having interest and debt for years. 

Typically, short-run loans are given for six months to one-year periods, so there is no worry about a ten-year or more loan paid back yearly or quarterly, such as student debt. 

Quarters

This means that there is less time for interest to accrue, as there is usually no time to build up over such a short period. This is very useful for debt management, as payments are often made in single or few installments. But, of course, this is contingent on paying back the loan when due.

Furthermore, practically short-term loans are much more accessible. This is to say that while long-term loans require an approval process that may take longer than when you need the cash, sometimes this destroys the entire purpose of taking a loan, while short-term loans do not. 

Often, these loans are processed within a business day, and the money is directly deposited into your account. This makes a difference again to the immediate access to money. Another benefit that is a reason for such quick approval of loans is that the lenders are less stringent. 

While long-term loans may need creditworthiness and a rapport with the bank, short-run loans generally do not. Therefore, borrowers with poor credit ratings generally favor these quick loans.

Of course, not all is good when it comes to using STIRs. Since the loan has less time to accrue interest, lenders need a justification to use short-term loans. This justification is a much higher interest rate.

This means that even if the time for interest to build is less, the payable amount relative to the loan can still be high. This also leads to a secondary problem of the debt cycle. A debt cycle is when the person continuously receiving the loans uses loans and cannot escape a lifestyle of relying on debt. 

How do I calculate interest on a short-term loan?

There are a few steps involved in calculating the interest rates on short-term loans. First, you need to find out the type of interest and the rate charged - namely compound or simple interest. Take the amount of the loan and divide it by the smallest unit of the percentage. 

For instance, if the interest is 6%, divide by 100. If interest is 6.6%, divide by 1000. Then, multiply this number by the number without any decimals (e.g., divide by 1000, then multiply by 66). This should be the interest charged during this time period.

Calculator

If the interest is compound, then use this formula:

Equation

First, take the principal value (p) by 1+ the interest rate in terms of decimals. Then, put this value to the power of n, n being years the loan has had to mature. This should then be the value of the interest cost.

Are short-term rates volatile?

Short-term rates are more volatile than long-term rates; however, long-term bonds are more sensitive to changes in interest rates than short-term bonds. Short-term rates are subject to the central bank and commercial banks and can therefore change in a flash.

However, long-term bonds are more sensitive due to the fixed-income nature of bonds. When interest rates rise, the longest-term bonds are the most sensitive to rate changes. 

This is because the bond returns are fixed, and when interest rates go up, bond prices go down. Long-term bonds have longer to mature and therefore have more coupon payments remaining that could return at higher or lower prices.

The macro scale behind loans in the short run is to increase liquidity and secure stable prices. Interest rates in the short run are more stable than long-run interest rates. 

Central banks set the STIRs to ensure an adequate level of cash flow in the economy. The actions of the central bank affect LIBOR and Prime Rates. LIBOR rates are the rates banks charge each other for overnight loans. LIBOR stands for London InterBank Offering Rate.

Prime Rates is the price that affects the customers, as it is the rate that affects the best customers. 

Short-term interest rates are seen to encourage risk-taking behavior, similarly to individuals, in commercial banks. When short-term interest is low, banks tend to relax their lending standards. This is because they can give loans to individuals with lower credit ratings and higher credit risk.

Because the loan rate is low, they are able to spread the risk across multiple lenders in a way that traditionally, banks would not. In the short-run, this is seen as beneficial as it makes bank portfolios less risky. 

Banks

However, in the medium to long run, the risky credit lending of commercial banks can lead to a destabilization of the financial system. If too many individuals are unable to repay loans, it causes many people to default on their loans, thus increasing the non-performing assets of the banks.

An example of this is the 2008 financial crisis, where risky lending led to a mass default on loans.

What is a term structure, and why is it important for STIRs?

Term structure is the relationship between short and long-term interest rates. These interest rates are positively correlated. While the short-term fluctuates more than long-term interest, the latter fluctuates by a greater percentage in price. 

Term structure is commonly depicted using the yield curve, which plots the yield to maturity against the time to maturity, with the yield on the y-axis and term/time on the x-axis.

  • Upwards sloping curves occur when interest rates are low
  • Downwards sloping curves indicate the opposite - high-interest rates
  • Flat is in between - medium or neutral interest rates

These concepts are important as they also depict the relationship between long-term and short-term bond yields. As yield is in line with maturity, the term structure can strongly indicate the market's risk tolerance.

Math

 Again, the three types of slopes can indicate how the market feels about short and long term yields:

  • Upwards sloping curves indicate that yields are higher for the long-term over short-term yields.
  • Downwards sloping curves indicate the opposite but also imply that the economy is contracting.
  • Flat again is in between with little difference in the yields of both forms of yield, implying that the economy is unsure about the future.

Term structures are affected by a combination of interest rates, inflation expectations, and risk premiums

Find more useful information on calculating interest rate curves in this forum post.

What is STIR trading (STIRT)?

Short-Term Interest Rate Trading is known as STIRT. STIR traders trade short-term derivatives, including futuresderivatives, and swaps. They are subsets of interest rate futures, which are a particular type of interest rate derivative.

Interest rate derivative payments are repaid by the interest rate or set of interest rates. Interest rate futures have this derivative as the underlying asset. STIR are futures contracts that again take this value with the interest rates based on a short-term index, such as 3-month average interest rate securities. 

Common examples of short term futures are:

  • Eurodollar
  • Euribor
  • Euroyen
  • Short Sterling
  • Euroswiss  

 These are commonly time deposits denominated in the suffix currency. They are often calculated using LIBOR.

Euro

Futures contracts are legal agreements to buy and sell an asset at a predetermined price at a point in the future, determined by both parties. The most widely traded futures contract is the International Monetary Market Eurodollar interest rate future. Eurodollar and Euribor are traded for trillions of dollars and euros daily.

What is speculation on STIRs useful for?

Short-term interest rate futures are often used to hedge on interest rate swaps, caps, floors, and collars. For more information on hedging, click on the link.

Trading on futures requires speculation on whether the future will rise or fall in the following months. For short-term futures, this speculation is based commonly on three-month average interest rates. The main use of betting on these STIR derivatives is to hedge against interest rate risk in short-term lending.

Interest rate risk, or interest rate exposure, is the potential for loss that results from a result in changing interest rates. Hedging against these changes commonly means that the individual hedging the bet gains from the investment declining in value. 

Interest Rates

Call buyers on futures of STIRs bet interest rates will rise, while put buyers bet interest rates will fall. These call and put options allow buyers of STIR securities to hedge and speculate. 

Buyers of call options are not subject to the risk of the fluctuations of the underlying stock. These buyers are known as bullish buyers and buy the stock in the hope that the value will increase before the option expires. The risk to the buyer is only the money they put into the stock. 

If the value of the stock decreases, then the buyer loses money. Equally, sellers of call options benefit from the opposite. If the value of the stock decreases, the seller gains the value difference.

Buyers of put options again hope the stock price in the market will decrease. They make money when the put option is below the agreed strike price

The cost to the buyer is if the option does not fall enough and expires by the given date. The selling of the put option hopes for the stock to stay the same or increase by the expiry date of the bond.

Generally, there are expiration dates on all short-term bonds. These expiration dates follow the system of the International Money Market. The third Wednesday of March and each following three months. 

The IMM is the most important money market, as it includes U.S. dollar currencies, British Pound, the Euro, as well as the LIBOR, and the CPI.

LBO Modeling Course

Everything You Need To Master LBO Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: