17765786 Determinants of Interest Rate 1

8/3/2019 17765786 Determinants of Interest Rate 1

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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.
http://www.investorwords.com/2908/M1.htmlhttp://www.investorwords.com/2909/M2.htmlhttp://www.investorwords.com/2910/M3.htmlhttp://www.businessdictionary.com/definition/measure.htmlhttp://www.businessdictionary.com/definition/measure.htmlhttp://www.investorwords.com/2910/M3.htmlhttp://www.investorwords.com/2909/M2.htmlhttp://www.investorwords.com/2908/M1.html


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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 .
http://www.investorwords.com/2909/M2.htmlhttp://www.investorwords.com/2909/M2.html


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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.
http://www.investorwords.com/2908/M1.htmlhttp://www.businessdictionary.com/definition/savings.htmlhttp://www.businessdictionary.com/definition/savings.htmlhttp://www.investorwords.com/2908/M1.html


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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.

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17765786 Determinants of Interest Rate 1

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