Determinants of interest Determinants of interest raterate

Borrowing and lending in the financial market Borrowing and lending in the financial market depend to a significant extent on the rate of depend to a significant extent on the rate of interest. In economics interest is a payment for interest. In economics interest is a payment for the services of capital. It represents a return on the services of capital. It represents a return on capital. capital.

Interest is the price of hiring capital. Capital, Interest is the price of hiring capital. Capital, as a factor of production, takes the form of as a factor of production, takes the form of machinery, equipment or any other physical machinery, equipment or any other physical assets used in production of goods. assets used in production of goods.

On the other hand, funds must be made On the other hand, funds must be made available to the entrepreneurs for buying these available to the entrepreneurs for buying these physical assets. Purchase of capital assets is physical assets. Purchase of capital assets is called investment and funds made available called investment and funds made available for the purchase of such capital assets is called for the purchase of such capital assets is called financial capital. Some persons have to supply financial capital. Some persons have to supply this financial capital to the entrepreneurs who this financial capital to the entrepreneurs who would use it for investment in real capital would use it for investment in real capital assets.assets.

Market rate of interestMarket rate of interest

The payment to those who supply financial The payment to those who supply financial capital for its use is called the capital for its use is called the market rate market rate of of interest. interest. This is expressed as a percentage of This is expressed as a percentage of sum of funds borrowed. sum of funds borrowed.

Return on capitalReturn on capital

The entrepreneur who buys capital equipment The entrepreneur who buys capital equipment and uses it in the process of production gets and uses it in the process of production gets addition to his revenue, which is called addition to his revenue, which is called return return on capital. on capital. The return on capital is the The return on capital is the addition to production which increases his addition to production which increases his revenuerevenue

The interest rate is determined by demand and The interest rate is determined by demand and supply: the demand for present control of supply: the demand for present control of resources by those who do not have it, and the resources by those who do not have it, and the supply from those who do have control and are supply from those who do have control and are willing to surrender it for a price. willing to surrender it for a price.

PURE INTEREST AND GROSSPURE INTEREST AND GROSSINTEREST RATESINTEREST RATES

According to Prof. Meyers, interest is the price According to Prof. Meyers, interest is the price paid for the use of loan able funds. Different paid for the use of loan able funds. Different rates of interest are charged for the same sum rates of interest are charged for the same sum of loan for the same period because of the fact of loan for the same period because of the fact that some loans involve more risk, more that some loans involve more risk, more inconvenience and more incidental work. inconvenience and more incidental work.

Types of interest rateTypes of interest rate

Pure interest rate Pure interest rate Gross interest rateGross interest rate

The The pure interest pure interest is the payment for the use is the payment for the use of money as capital when there is neither of money as capital when there is neither inconvenience risk nor any other management inconvenience risk nor any other management problem.problem.

Gross interest Gross interest is the gross payment which the is the gross payment which the lender gets from the borrower. It includes not lender gets from the borrower. It includes not only net interest but also payment for other only net interest but also payment for other elements, which have been outlined below.elements, which have been outlined below.

Elements of Gross interestElements of Gross interest

Payment for risk Payment for risk : Every loan, if not secured : Every loan, if not secured fully, involves risk of non- payment due to the fully, involves risk of non- payment due to the inability or unwillingness of the borrower to inability or unwillingness of the borrower to pay back the debt. The lender charges pay back the debt. The lender charges something extra for taking such risk.something extra for taking such risk.

Payment for inconvenience Payment for inconvenience : The moneylender may : The moneylender may add extra charges for the inconvenience caused to add extra charges for the inconvenience caused to him. The greater the inconvenience involved, the him. The greater the inconvenience involved, the higher will be such charge and consequently the gross higher will be such charge and consequently the gross interest. For instance,the borrower may repay at a interest. For instance,the borrower may repay at a very inconvenient time to the lender or the borrower very inconvenient time to the lender or the borrower may invest the capital for a period longer than the one may invest the capital for a period longer than the one for which loan has been given.for which loan has been given.

Payment for management Payment for management : The lender : The lender expects to be compensated for the additional expects to be compensated for the additional work he has to do in connection with lending work he has to do in connection with lending e.g., the form of keeping accounts, sending e.g., the form of keeping accounts, sending notices and reminders and other incidental notices and reminders and other incidental work.work.

Payment for exclusive use of money, i.e. Payment for exclusive use of money, i.e. pure interest:pure interest:

It is the payment for the use of money which is It is the payment for the use of money which is in addition to payments for the above-in addition to payments for the above-mentioned risks, inconvenience and mentioned risks, inconvenience and management.management.

Real interest rate Real interest rate

Alternative term for real rate of interestAlternative term for real rate of interest

nominal interest ratenominal interest rate

DefinitionDefinition Market interest rate unadjusted to reflect the Market interest rate unadjusted to reflect the

erosion of the purchasing power due to erosion of the purchasing power due to inflation . inflation .

A nominal variable, such as a nominal interest A nominal variable, such as a nominal interest rate, is one where the effects of inflation have rate, is one where the effects of inflation have not been accounted for. Changes in the not been accounted for. Changes in the nominal interest rate often move with changes nominal interest rate often move with changes in the inflation rate.in the inflation rate.

Real interest rates are interest rates where Real interest rates are interest rates where inflation has been accounted for. inflation has been accounted for.

Theory of term structure of interest Theory of term structure of interest rates rates

Changes in the level of interest rate, which arise Changes in the level of interest rate, which arise due to changes in the rate of inflation, unusual due to changes in the rate of inflation, unusual risk premiums, changing credit conditions, risk premiums, changing credit conditions, there are changes, which are termed as the there are changes, which are termed as the 'term structure of interest rate' 'term structure of interest rate'

Yield curveYield curve

Relationship between yields and maturities of Relationship between yields and maturities of bonds in given default risk classes. bonds in given default risk classes. The The relationship is usually presented graphically as relationship is usually presented graphically as Yield Curve'. Yield Curve'.

The yield curve changes a little everyday and The yield curve changes a little everyday and there are different yield curves for each class there are different yield curves for each class of bonds. The yield curve for the riskier of bonds. The yield curve for the riskier classes of bonds are at a higher level than the classes of bonds are at a higher level than the yield curve for less risky bonds. The yield curve for less risky bonds. The difference in levels is due to the difference in difference in levels is due to the difference in risk premium. risk premium.

The Liquidity Preference TheoryThe Liquidity Preference Theory

According to Liquidity Preference Theory, According to Liquidity Preference Theory, lenders prefer short-term securities over long lenders prefer short-term securities over long term securities, unless the yield on the longer-term securities, unless the yield on the longer-term securities are high enough to compensate term securities are high enough to compensate for the greater interest rate risk. for the greater interest rate risk.

Expectations TheoryExpectations Theory

The Expectation theory hypothesizes that The Expectation theory hypothesizes that investors‘ expectation alone shape the yield investors‘ expectation alone shape the yield curve. curve.

Its validity rests on the assumption that investors Its validity rests on the assumption that investors are indifferent to any variation in risks are indifferent to any variation in risks associated with different maturities. associated with different maturities.

Market Segmentation TheoryMarket Segmentation Theory

According to market segmentation theory, According to market segmentation theory, interest rates for various maturities are interest rates for various maturities are determined by demand and supply conditions determined by demand and supply conditions in the relevant segments of the market. in the relevant segments of the market.

The interest rates are generally referred to as spot and The interest rates are generally referred to as spot and forward rates:-forward rates:-

Forward rate refers to yield to maturity for bond Forward rate refers to yield to maturity for bond which is expected to exist in future:which is expected to exist in future:

Spot rate:- refers to the interest rate for bond, which Spot rate:- refers to the interest rate for bond, which currently exists and is being currently bought and currently exists and is being currently bought and sold. sold.

Forward rates are implicit. These rates cannot be Forward rates are implicit. These rates cannot be observed, whereas, spot rates can be observed.observed, whereas, spot rates can be observed.

The segmentation theory holds that financial The segmentation theory holds that financial markets are divided into different maturity markets are divided into different maturity wise segments, and the rate of interest in each wise segments, and the rate of interest in each of this segments is determined by its supply of of this segments is determined by its supply of and demand for funds. and demand for funds.

Determinants of general structure of Determinants of general structure of interest ratesinterest rates

Default risk: it refers to the possibility of an Default risk: it refers to the possibility of an adverse outcome to an event. All financial adverse outcome to an event. All financial assets, except governments securities are assets, except governments securities are subject to some degree of default risk although subject to some degree of default risk although they differ in their degree of risk.they differ in their degree of risk.

Marketability or liquidity:Marketability or liquidity: The financial assets differ in their The financial assets differ in their

marketability or liquidity that is they differ in marketability or liquidity that is they differ in respect of the possibility that a significant respect of the possibility that a significant amount of security can be sold relatively amount of security can be sold relatively quickly without price concessions. quickly without price concessions.

Tax status: tax features cause difference on Tax status: tax features cause difference on similar financial assets or claims.similar financial assets or claims.

FACTORS AFFECTING MARKETFACTORS AFFECTING MARKETINTEREST RATESINTEREST RATES

Economic ConditionsEconomic Conditions Interest rates have a tendency to move up and down Interest rates have a tendency to move up and down

with changes in the volume of business activities. In with changes in the volume of business activities. In period of rapid economic growth, business firms period of rapid economic growth, business firms require large amount of capital to finance increased require large amount of capital to finance increased requirements of working capital and fixed asset. requirements of working capital and fixed asset.

The business demand for borrowed funds, combined The business demand for borrowed funds, combined with increase in consumer borrowing put upward with increase in consumer borrowing put upward pressure on interest rates.pressure on interest rates.

Monetary PolicyMonetary PolicyMonetary policy refers to the policy measures adopted byMonetary policy refers to the policy measures adopted bythe Central Bank of the country such as changes in rate ofthe Central Bank of the country such as changes in rate ofinterest (i.e, change in cost of credit) and the availability ofinterest (i.e, change in cost of credit) and the availability ofcredit. The policy regarding the growth of money supplycredit. The policy regarding the growth of money supplyalso comes under the purview of monetary policy. Changesalso comes under the purview of monetary policy. Changesin bank rate, open market operations, cash reserve ratio ofin bank rate, open market operations, cash reserve ratio ofbanks, selective credit controls are the various instrumentsbanks, selective credit controls are the various instrumentsof monetary policy.of monetary policy.

Bank RateBank Rate

Bank rate is the rate at which the central bank Bank rate is the rate at which the central bank of a country provides loans to the commercial of a country provides loans to the commercial banks. Bank rate is also called the discount banks. Bank rate is also called the discount rate because in the earlier days, the central rate because in the earlier days, the central bank used to provide finance to the bank used to provide finance to the commercial banks by rediscounting their bills commercial banks by rediscounting their bills of exchange.of exchange.

Measures of money supplyMeasures of money supply The total supply of money in circulation in a given country's The total supply of money in circulation in a given country's

economy at a given time. There are several measures for the economy at a given time. There are several measures for the money supply, such as M1, M2, and M3. money supply, such as M1, M2, and M3.

The money supply is considered an important instrument for The money supply is considered an important instrument for controlling inflation by those economist who say that growth in controlling inflation by those economist who say that growth in money supply will only lead to inflation if money demand is money supply will only lead to inflation if money demand is stable stable

In order to control the money supply, regulators have to decide In order to control the money supply, regulators have to decide which particular which particular measuremeasure of the money supply to target . of the money supply to target .

The broader the targeted measure, the more difficult it will be to The broader the targeted measure, the more difficult it will be to control that particular target. However, targeting an unsuitable control that particular target. However, targeting an unsuitable narrow money supply measure may lead to a situation where the narrow money supply measure may lead to a situation where the total money supply in the country is not adequately controlled.total money supply in the country is not adequately controlled.

M1M1

One measure of the money supply that One measure of the money supply that includes all coins currency held by the public includes all coins currency held by the public travelers cheque , checking account travelers cheque , checking account balances ,New account , atomic transfers balances ,New account , atomic transfers service accounts, and balances in credit service accounts, and balances in credit unions.unions.

M3M3

One measure of the money supply that One measure of the money supply that includes M2, plus large time deposits , repos includes M2, plus large time deposits , repos of maturity greater than one day at commercial of maturity greater than one day at commercial banks , and institutional money market banks , and institutional money market institutions .institutions .

M2M2

One measure of the money supply that One measure of the money supply that includes M1plus includes M1plus savingssavings and small time and small time deposits overnight repos at commercial banks , deposits overnight repos at commercial banks , and non-institutional money market accounts . and non-institutional money market accounts . A key economic indicator used to forecast A key economic indicator used to forecast inflation.inflation.

M1 consists of the most highly liquid assets. M1 consists of the most highly liquid assets. That is, M1 includes all forms of assets that That is, M1 includes all forms of assets that are easily exchangeable as payment for goods are easily exchangeable as payment for goods and services. It consists of coin and currency and services. It consists of coin and currency in circulation, traveler's checks, demand in circulation, traveler's checks, demand deposits, and other checkable deposits deposits, and other checkable deposits

M2 is a broader measure of money than M1. It M2 is a broader measure of money than M1. It includes all of M1, the most liquid assets, and includes all of M1, the most liquid assets, and a collection of additional assets that are a collection of additional assets that are slightly less liquid. These additional assets slightly less liquid. These additional assets include savings accounts, money market include savings accounts, money market deposit accounts, small time deposits (less deposit accounts, small time deposits (less than $100,000) (these would include than $100,000) (these would include certificates of deposits) and retail money certificates of deposits) and retail money market mutual funds. market mutual funds.

M3 is an even broader definition of the money M3 is an even broader definition of the money supply, including M2 and other assets even supply, including M2 and other assets even less liquid than M2. As the number gets larger, less liquid than M2. As the number gets larger, 1 … 2 … 3, the assets included become less 1 … 2 … 3, the assets included become less and less liquid. and less liquid.