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Determinants of interest
rate
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Borrowing and lending in the financial marketdepend to a significant extent on the rate ofinterest. In economics interest is a payment for
the services of capital. It represents a return oncapital.
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Interest is the price of hiring capital. Capital,
as a factor of production, takes the form of
machinery, equipment or any other physical
assets used in production of goods.
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On the other hand, funds must be made
available to the entrepreneurs for buying these
physical assets. Purchase of capital assets is
called investment and funds made available forthe purchase of such capital assets is called
financial capital. Some persons have to supply
this financial capital to the entrepreneurs whowould use it for investment in real capital
assets.
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Market rate of interest
The payment to those who supply financial
capital for its use is called the market rate of
interest. This is expressed as a percentage of
sum of funds borrowed.
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Return on capital
The entrepreneur who buys capital equipment
and uses it in the process of production gets
addition to his revenue, which is called return
on capital. The return on capital is theaddition to production which increases his
revenue
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The interest rate is determined by demand and
supply: the demand for present control of
resources by those who do not have it, and the
supply from those who do have control and arewilling to surrender it for a price.
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PURE INTEREST AND GROSS
INTEREST RATES
According to Prof. Meyers, interest is the price
paid for the use of loan able funds. Different
rates of interest are charged for the same sum
of loan for the same period because of the factthat some loans involve more risk, more
inconvenience and more incidental work.
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Types of interest rate
Pure interest rate
Gross interest rate
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The pure interest is the payment for the use of
money as capital when there is neither
inconvenience risk nor any other management
problem.
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Gross interest is the gross payment which the
lender gets from the borrower. It includes not
only net interest but also payment for other
elements, which have been outlined below.
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Elements of Gross interest
Payment for risk : Every loan, if not secured
fully, involves risk of non- payment due to the
inability or unwillingness of the borrower to
pay back the debt. The lender chargessomething extra for taking such risk.
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Payment for inconvenience : The moneylender may
add extra charges for the inconvenience caused to
him. The greater the inconvenience involved, the
higher will be such charge and consequently the grossinterest. For instance,the borrower may repay at a
very inconvenient time to the lender or the borrower
may invest the capital for a period longer than the one
for which loan has been given.
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Payment for management : The lender
expects to be compensated for the additional
work he has to do in connection with lending
e.g., the form of keeping accounts, sendingnotices and reminders and other incidental
work.
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Payment for exclusive use of money, i.e.
pure interest:
It is the payment for the use of money which is
in addition to payments for the above-
mentioned risks, inconvenience and
management.
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Real interest rate
Alternative term for real rate of interest
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nominal interest rate
Definition
Market interest rate unadjusted to reflect the
erosion of the purchasing power due to
inflation .
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A nominal variable, such as a nominal interest
rate, is one where the effects of inflation have
not been accounted for. Changes in the
nominal interest rate often move with changesin the inflation rate.
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Real interest rates are interest rates where
inflation has been accounted for.
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Theory of term structure of interest
rates
Changes in the level of interest rate, which arise
due to changes in the rate of inflation, unusual
risk premiums, changing credit conditions,
there are changes, which are termed as the'term structure of interest rate'
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Yield curve
Relationship between yields and maturities of
bonds in given default risk classes. The
relationship is usually presented graphically as
Yield Curve'.
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The yield curve changes a little everyday and
there are different yield curves for each class
of bonds. The yield curve for the riskier
classes of bonds are at a higher level than theyield curve for less risky bonds. The difference
in levels is due to the difference in risk
premium.
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The Liquidity Preference Theory
According to Liquidity Preference Theory,
lenders prefer short-term securities over long
term securities, unless the yield on the longer-
term securities are high enough to compensatefor the greater interest rate risk.
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Expectations Theory
The Expectation theory hypothesizes that
investors expectation alone shape the yield
curve.
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Its validity rests on the assumption that investors
are indifferent to any variation in risks
associated with different maturities.
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Market Segmentation Theory
According to market segmentation theory,
interest rates for various maturities are
determined by demand and supply conditions
in the relevant segments of the market.
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The interest rates are generally referred to as spot andforward rates:-
Forward rate refers to yield to maturity for bond
which is expected to exist in future: Spot rate:- refers to the interest rate for bond, which
currently exists and is being currently bought andsold.
Forward rates are implicit. These rates cannot beobserved, whereas, spot rates can be observed.
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The segmentation theory holds that financial
markets are divided into different maturity
wise segments, and the rate of interest in each
of this segments is determined by its supply ofand demand for funds.
Determinants of general structure of
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Determinants of general structure of
interest rates
Default risk: it refers to the possibility of an
adverse outcome to an event. All financial
assets, except governments securities are
subject to some degree of default risk althoughthey differ in their degree of risk.
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Marketability or liquidity:
The financial assets differ in their
marketability or liquidity that is they differ in
respect of the possibility that a significant
amount of security can be sold relatively
quickly without price concessions.
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Tax status: tax features cause difference on
similar financial assets or claims.
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FACTORS AFFECTING MARKET
INTEREST RATES
Economic Conditions
Interest rates have a tendency to move up and downwith changes in the volume of business activities. Inperiod of rapid economic growth, business firmsrequire large amount of capital to finance increasedrequirements of working capital and fixed asset.
The business demand for borrowed funds, combined
with increase in consumer borrowing put upwardpressure on interest rates.
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Monetary Policy
Monetary policy refers to the policy measures adopted by
the Central Bank of the country such as changes in rate of
interest (i.e, change in cost of credit) and the availability of
credit. The policy regarding the growth of money supply
also comes under the purview of monetary policy. Changes
in bank rate, open market operations, cash reserve ratio of
banks, selective credit controls are the various instruments
of monetary policy.
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Bank Rate
Bank rate is the rate at which the central bank
of a country provides loans to the commercial
banks. Bank rate is also called the discount
rate because in the earlier days, the central
bank used to provide finance to the
commercial banks by rediscounting their billsof exchange.
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Measures of money supply
The total supply of money in circulation in a given country'seconomy at a given time. There are several measures for themoney supply, such as M1, M2, and M3.
The money supply is considered an important instrument forcontrolling inflation by those economist who say that growthin money supply will only lead to inflation if money demand isstable
In order to control the money supply, regulators have to decidewhich particular measure of the money supply to target .
The broader the targeted measure, the more difficult it will beto control that particular target. However, targeting anunsuitable narrow money supply measure may lead to asituation where the total money supply in the country is not
adequately controlled.
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M1
One measure of the money supply that
includes all coins currency held by the public
travelers cheque , checking account balances
,New account , atomic transfers serviceaccounts, and balances in credit unions.
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M3
One measure of the money supply that
includes M2, plus large time deposits , repos of
maturity greater than one day at commercial
banks , and institutional money marketinstitutions .
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M2
One measure of the money supply that includes
M1plus savings and small time deposits
overnight repos at commercial banks , and
non-institutional money market accounts . Akey economic indicator used to forecast
inflation.
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M1 consists of the most highly liquid assets.
That is, M1 includes all forms of assets that are
easily exchangeable as payment for goods and
services. It consists of coin and currency incirculation, traveler's checks, demand deposits,
and other checkable deposits
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M2 is a broader measure of money than M1. It
includes all of M1, the most liquid assets, and
a collection of additional assets that are
slightly less liquid. These additional assetsinclude savings accounts, money market
deposit accounts, small time deposits (less than
$100,000) (these would include certificates ofdeposits) and retail money market mutual
funds.
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M3 is an even broader definition of the money
supply, including M2 and other assets even
less liquid than M2. As the number gets larger,
1 2 3, the assets included become lessand less liquid.