Determinants Of Interest Rate 1

Determinants of interest rate



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



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.



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 for the purchase of such capital assets is called financial capital. Some persons have to supply this financial capital to the entrepreneurs who would use it for investment in real capital assets.

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.

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 the addition to production which increases his revenue



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 are willing to surrender it for a price.

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 fact that some loans involve more risk, more inconvenience and more incidental work.

Types of interest rate  

Pure interest rate Gross interest rate



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



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.

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 charges something extra for taking such risk.



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 gross interest. 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.



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, sending notices and reminders and other incidental work.





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 abovementioned risks, inconvenience and management.

Real interest rate 

Alternative term for real rate of interest

nominal interest rate  

Definition Market interest rate unadjusted to reflect the erosion of the purchasing power due to inflation .



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 changes in the inflation rate.



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

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'

Yield curve 

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

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 the yield curve for less risky bonds. The difference in levels is due to the difference in risk premium.

The Liquidity Preference Theory 

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

Expectations Theory 

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

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

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.









The interest rates are generally referred to as spot and forward 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 and sold. Forward rates are implicit. These rates cannot be observed, whereas, spot rates can be observed.



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 of and demand for funds.

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 although they differ in their degree of risk.

 

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.



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

FACTORS AFFECTING MARKET INTEREST RATES Economic Conditions  Interest rates have a tendency to move up and down with changes in the volume of business activities. In period of rapid economic growth, business firms require large amount of capital to finance increased requirements of working capital and fixed asset.  The business demand for borrowed funds, combined with increase in consumer borrowing put upward pressure on interest rates.

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. 



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 bills of exchange.

Measures of money supply 

The total supply of money in circulation in a given country's economy at a given time. There are several measures for the money supply, such as M1, M2, and M3.



The money supply is considered an important instrument for controlling inflation by those economist who say that growth in money supply will only lead to inflation if money demand is stable In order to control the money supply, regulators have to decide which particular measure of the money supply to target .





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

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 service accounts, and balances in credit unions.

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 market institutions .

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 . A key economic indicator used to forecast inflation.



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 in circulation, traveler's checks, demand deposits, and other checkable deposits



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 assets include savings accounts, money market deposit accounts, small time deposits (less than $100,000) (these would include certificates of deposits) and retail money market mutual funds.



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 less and less liquid.