Interest Rates in the Financial System

Interest rates are among the most closely watched

variables in the economy. Their movements are

reported almost daily by the news media, because
they directly affect our everyday lives and have
important consequences on the health of the
economy.
They affect personal decisions such as whether to
consume or save……Interest rates also affect the
economic decisions of businesses and households,
such as whether to use their funds to invest or to
save.
The acts of saving and lending, and borrowing
and investing, are significantly influenced by and
tied together by the interest rate.
 What is interest rate?
− The interest rate is the price a borrower must
pay to secure scarce loanable funds from a
lender for an agreed-upon time period.
• Some authors refer to the rate of interest as
the price of credit.
• It is the rental price of money usually expressed
as a percentage of the principal amount of
money borrowed
• It is the reward for parting with the money
and for postponing current consumption.
• To the person borrowing the money interest is the
penalty for consuming income before it is earned.
The interest rate helps guarantee that current
savings will flow into investment to promote
economic growth.

It allocates the available supply of credit,

generally providing loanable funds to those
investment projects with the highest expected
returns.
It brings the supply of money into balance
with the public’s demand for money.

The interest rate serves as an important tool

for government policy through its influence
on the volume of savings and investment.
 Pure or Risk-free rate of Interest
 ……we assume that there is one fundamental interest rate,
known as the pure or risk-free rate of interest, which is a
component of all interest rates.

• The closest real-world approximation to this pure

rate of return is the market interest rate on
government bonds.
• There are different theories regarding the
determinants of the risk free (pure) rate of
interest:

 The Classical Theory of interest rate

The Liquidity Preference Theory of interest rate
The Loanable Funds Theory of interest rate
The Rational Expectations Theory of interest rate
The classical theory argues that the rate of
interest is determined by two forces:
− the supply of savings, derived mainly from
households, and
− the demand for investment capital, coming mainly
from the business sector.
According to this theory the rate of interest is
determined by the interaction of savings and
investment.
 Household Savings
Current household savings equal the difference
between current income and current
consumption expenditures.
Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
Higher interest rates encourage the substitution
of current consumption for current saving
 The Demand for Investment Funds

One investment decision-making method involves

the calculation of a project’s expected internal rate
of return, and the comparison of that expected return
with the anticipated returns of alternative projects, as
well as with market interest rates.
 The internal rate of return (r) equates the total

cost of an investment project with the future

net cash flows (NCF) expected from that
project discounted back to their present values.
− Accept the project if the IRR is greater than the

cost of capital.

– Reject the project if the IRR is less than the cost of

capital.

– We are indifferent to accept or reject the project

when the IRR is equal to the cost of capital
• Unlike savings, investment is inversely

related to interest. The higher the interest

rate the lower is the demand for investment
capital.
 …..
Factors other than savings and investment

that affect interest rates are ignored.

Today, economists recognize that income is

more important than interest rates in

determining the volume of savings.
According to this theory the rate of interest

is determined by the demand for and supply

of money.
The supply of money is institutionally given. Hence, the
supply of money represents a vertical line. The supply
of money is independent of level of income and the
change in rate of interest.
Liquidity preference is the preference to have an
equal volume of cash rather than other financial
claims against others.

There are three important motives behind the

demand for money (liquidity):
i. The transactions motive - day to day transactions -the
purchase of goods and services
ii. The precautionary motive - to cope with future
emergencies and extraordinary expenses
iii. The speculative motive - a rise in interest rates results
in lower bond prices
It is desire to hold wealth to take advantage of market
movements
Limitations
Only the supply and demand for money is
Considered. A more comprehensive view that
considers the supply and demand for credit by all
actors in the financial system - businesses,
households, and governments - is needed.
 The popular loanable funds theory argues that the risk-free
interest rate is determined by the interplay of two forces:

 the demand for credit (loanable funds) by domestic

businesses, consumers, and governments, as well as

foreign borrowers

 the supply of loanable funds from domestic savings,

dishoarding of money balances, foreign lending

The rational expectations theory builds on a
growing body of research evidence that

………the money and capital markets are highly

efficient in digesting new information that affects
interest rates and security prices
 The public forms rational and unbiased
expectations about the future demand and supply
of credit, and hence interest rates.
• If the money and capital markets are highly efficient,
then interest rates will always be very near their
equilibrium levels, and the optimal forecast of next
period’s interest rate is the current interest rate.
• Interest rates will change only if entirely new and
unexpected information appears, and the direction of
change depends on the public’s current set of
expectations.
Limitations
− At the moment, we do not know very much about how the

public forms its expectations.

− The cost of gathering and analyzing information relevant to

the pricing of assets is not always negligible, as assumed.

− Not all interest rates and security prices appear to display the

kind of behavior implied by the rational expectations theory.

 In addition to the expected inflation and maturity, other

factors affecting interest rates include:

• marketability,

• default risk,

• call privileges,

• taxation of security income,

• convertibility
 Marketability – Can an asset be sold quickly?

Marketability is positively related to the size and

reputation of the institution issuing the securities and

to the number of similar securities outstanding.

However, marketability is negatively related to yield.

Liquidity – A liquid financial asset is readily
marketable.
• Default risk – The risk that a borrower will not make all

the promised payments at the agreed upon times.

Promised yield on a risky asset

• The promised yield on a risky debt security is the yield to

maturity that will be earned by the investor if the borrower

makes all promised payments when they are due.
• Credit ratings by rating companies such as

Moody’s and Standard & Poor’s

• Highly-rated securities are perceived as
having negligible default risk.
• A call privilege on a bond contract grants the borrower

the option to retire all or a portion of a bond issue by

buying back the securities in advance of maturity at a
specified call price.

• A bond may be callable immediately, or the privilege

may be deferred for a specified period of time.

Taxes imposed by the federal, state, and local

governments can have a profound effect on the

returns earned by investors on financial assets.

 Thus, governments can use their taxing power to

encourage the investment in certain financial assets,

thereby redirecting the flow of savings and
investment toward areas of critical social need.
 Convertible (or hybrid) securities are special

issues of corporate bonds or preferred stock

that can be exchanged for a specific number
of shares of the issuing firm’s common stock.
• Convertibles offer the investor the prospect of

a stable interest or dividend income, as well as

capital gains on common stock on conversion.

• Hence, investors are generally willing to pay a

premium for convertibles.

 For the corporate bond issuer, the advantages of

convertible bonds is a significantly lower interest

cost and being able to avoid issuing more common

stock.
 Interest on convertible bonds is often a tax-

deductible expense in many countries too.

Note that the issuer may call in the securities
early, forcing conversion
 The risk-free interest rate underlies all interest rates

and is a component of all rates.

 All other interest rates are scaled upward by varying

degrees from the risk-free rate, depending on such

factors as inflation, the term (maturity) of a loan, the
risk of borrower default, and the marketability,
liquidity, convertibility, and tax status of the financial
assets to which those rates apply.