Chapter 2

Question 1

Understanding interest rates

Introduction

An interest rate is the percentage of extra money charged or earned on an amount of

money over time. When you borrow money (like a loan), you pay interest on it. When you
save money in a bank, you earn interest on your savings. It shows the cost of borrowing
or the reward for saving.

Example

If you take a loan from a bank or friend, you don’t just pay back the borrowed amount.
You also have to pay an additional amount called interest. This interest is based on the
percentage agreed between you and the lender. Higher interest rates mean more money
you will repay.

Types of interest rates

1. Simple Interest:

Simple Interest is calculated only on the original amount (principal) for the full loan
period. It does not change or grow with time. Used in short-term loans and fixed
deposits.

2. Compound Interest:

Compound Interest is calculated on both the principal and the accumulated interest. It
grows faster over time because interest is added back each period. Commonly used in
savings accounts, investments, and loans.

3. Fixed Interest Rate:

This rate stays constant throughout the loan or investment term. It provides stability and
predictability in payments. Common in personal loans and some home loans.

4. Floating (Variable) Interest Rate:

This rate changes based on market conditions or central bank rates. Your interest
payments can go up or down over time. Used in long-term loans like mortgages or
business loans.

5. Nominal Interest Rate:

It is the stated or advertised interest rate without adjusting for inflation.It shows the rate
you see in contracts but not the real value of money. Useful for comparing loan offers.
 6. Real Interest Rate:

It is the interest rate adjusted for inflation. It shows the actual gain in purchasing power.
Real Interest = Nominal Interest – Inflation Rate.

7. Annual Percentage Rate (APR):

APR includes the interest rate plus any additional fees or costs. It shows the true yearly
cost of borrowing. Helps compare different loan offers accurately.

Factors that Affect Interest Rates

While interest rates affect investment returns or loan repayment costs, it is also
influenced by factors like the economy’s strength, inflation, supply and demand,
government policy, credit risk, and loan period.

Economic Strength

A strong economy with low unemployment increases demand for goods and services,
which can increase rates as businesses attempt to borrow more money to meet this
demand. On the other hand, a weak economy results in lower interest rates as lenders
are less confident about lending their money due to the increased risk of default and
decreased need for borrowing.

Inflation

When inflation rises, so too do interest rates. This is because lenders require a higher
rate of return on their investment to make sure they do not lose out on purchasing
power due to rising costs of goods and services over time.

In such a scenario, borrowers must pay back more than the principal amount due to the
currency’s depreciation.

Government Policy

The government also plays an important role in determining interest rates, as they use
these to influence economic policy. For example, the Federal Reserve can raise or lower
short-term interest rates to manage inflation and stimulate the economy.

These changes usually have a ripple effect that affects other interest rates, such as
mortgage and credit card rates.

Supply and Demand

Interest rates are ultimately determined by supply and demand. When there is high
demand for credit, lenders can increase their rates as they have more opportunities to
lend out money at higher returns. On the other hand, when there is a low demand for
borrowing, lenders will lower their rates to make their services attractive to potential
borrowers.
Credit Risk

Generally, the riskier a loan is deemed by a lender, the higher the interest rate a
borrower must pay. This makes sense as it incentivizes lenders to take on more risky
investments and compensates them for the higher chance of default. High-risk loans
normally come with a base rate and a risk premium. The latter considers the borrower’s
credit risk and accordingly affects how much interest they will have to pay.

Time Period of the Loan

The length of the loan can also significantly affect interest rates. Generally, the longer
the loan period is, the higher the rate will be to cover any additional risks incurred by
lenders over time. For example, short-term loans come with many benefits, such that a
3 or 6-month installment loan usually comes with lower rates compared to long-term
ones such as mortgage or car finance loans.

Question 2

The behaviour of interest rates

Introduction

The behaviour of interest rate refers to the pattern and movement of interest rates over
time in response to various economic, financial, and policy-related factors. It includes
how interest rates rise or fall depending on changes in inflation, economic growth,
government borrowing, and central bank policies. Interest rates are not fixed; they
fluctuate regularly, and this fluctuation impacts loans, savings, investments, and overall
economic activity.

Factors Affecting the Behaviour of Interest Rate

a. Inflation

Inflation is the general increase in prices over time. When inflation is high, the
purchasing power of money decreases. To protect lenders from losing value on the
money they lend, interest rates are increased. This encourages saving and reduces
spending, helping to control inflation.

• High inflation = High interest rates.

• Low inflation = Lower interest rates.

Example: If inflation is 10%, lenders may demand 12% interest to ensure they still earn
a real return.

b. Monetary Policy

Monetary policy is controlled by the central bank (e.g., State Bank of Pakistan). It
adjusts interest rates to manage the economy. In times of low growth, the bank reduces
interest rates to encourage borrowing and spending. During high inflation, the bank
raises interest rates to slow down economic activity and stabilize prices.

Example: In a recession, interest rates are lowered to make loans cheaper and boost
investment.

c. Demand and Supply of Credit

When more people and businesses want to borrow money (high demand for credit),
interest rates tend to rise. When there is more money available to lend (high supply of
credit), interest rates may fall.

Example: During a business boom, companies seek more loans to expand, raising
interest rates due to higher demand.

d. Economic Growth

Strong economic growth leads to increased borrowing and investment. This creates
upward pressure on interest rates because demand for money rises. More employment,
higher income, and increased spending contribute to higher interest rates. To control
possible inflation from fast growth, central banks may also raise rates.

Example: Fast-growing countries often have slightly higher interest rates to manage
expansion.

e. Government Borrowing

When governments borrow large amounts to finance their budgets, they compete with
private borrowers. This increases demand in the loan market, pushing interest rates
higher.

Crowding out effect: Government borrowing can reduce funds available for private
investment, raising the cost of credit.

Example: If a government issues a lot of bonds, investors will demand higher interest
rates to buy them.

f. Exchange Rates and Foreign Investment

Interest rates also affect the flow of foreign capital. If a country has high interest rates, it
may attract foreign investors looking for better returns. If rates are low, investors may
move their money to other countries, causing currency depreciation. Thus, interest rate
behaviour is also linked with foreign exchange markets.

g. Central Bank Expectations

Future expectations about inflation, GDP growth, or global market conditions can
influence interest rates even before any policy change.
Example: If investors believe inflation will rise, they may demand higher interest rates on
new loans or bonds even before the central bank raises rates.

Conclusion

In summary, the behaviour of interest rates is shaped by several interconnected factors,

including inflation, monetary policy, credit demand and supply, economic growth, and
government borrowing. These factors determine whether interest rates rise, fall, or stay
stable.

Question 3

The risk and term structure of interest rate

Introduction

The term and risk structure of interest rates are key concepts in finance that explain why
interest rates differ across various financial instruments. The term structure refers to
the relationship between interest rates and the time to maturity of debt securities,
usually represented by a yield curve. On the other hand, the risk structure explains how
interest rates vary based on the credit risk, liquidity, and tax status of the issuer. Both
structures help investors and policymakers understand market expectations, assess
risk, and make informed financial decisions. Together, they provide a comprehensive
view of how interest rates behave in different conditions.

Term Structure of Interest Rates

The term structure of interest rates refers to the relationship between the interest rates
or yields of bonds and their time to maturity, assuming all other factors (like credit risk)
are constant. It is commonly illustrated through a yield curve, which shows yields on
bonds ranging from short-term to long-term.

Types of Yield Curves:

Normal yield curve – Upward-sloping, indicating longer maturities have higher interest
rates due to increased risk and inflation expectations.

Inverted yield curve – Downward-sloping, suggesting that short-term rates are higher
than long-term rates, often signaling a potential economic recession.

Flat yield curve – Interest rates are similar across all maturities, often seen during
periods of economic transition.

Theories Explaining the Term Structure:

Expectations Theory: Suggests long-term interest rates are an average of current and
expected future short-term rates. This theory assumes that investors are indifferent to
maturities.
Liquidity Preference Theory: Builds on expectations theory but adds a premium for
longer maturities due to greater risk, explaining the usual upward slope of the yield
curve.

Segmented Markets Theory: Argues that short-term and long-term bonds are not
substitutes. Interest rates for each maturity are determined by supply and demand in
separate markets.

Preferred Habitat Theory: A hybrid theory suggesting that while investors prefer
specific maturities, they will shift if adequately compensated for the additional risk or
inconvenience.

The term structure is crucial for forecasting future interest rates, inflation, and
economic activity. It is also used by central banks to design and implement monetary
policy.

Risk Structure of Interest Rates

Interest rates and yields on credit market instruments of the same maturity vary
because of differences in default risk, liquidity, information costs, and taxation. These
determinants are known collectively as the risk structure of interest rates.

Default Risk

Default risk is the probability that a borrower will not pay in full the promised interest,
principal, or both. The risk premium on a financial instrument is the difference between
its yield and the yield on a default-risk-free instrument of comparable maturity.
Generally, the larger the default risk, the larger the risk premium, the higher the interest
rate.

Liquidity

Because investors care about the cost required to convert a financial instrument into
cash, an increase in liquidity can make an instrument more desirable to investors, who
will then accept a lower rate of return. Thus a less liquid asset, called an illiquid asset,
must pay a higher yield in order to compensate savers for their sacrifice of liquidity. This
liquidity premium is commonly combined with default risk as part of the risk premium.

Information Costs

Gathering information requires resources and reduces the expected return on a

financial asset. Government bonds such as Treasury bills have the lowest information
costs because all savers know with certainty that the principal and interest will be
repaid. Information costs increase if the borrowers are not that well known and research
needs to be conducted before potential lenders are willing to buy bonds from such
borrowers. In short the higher the information costs, the higher the interest rate.
Taxation

Whether the financial instrument is exempted from taxation for interest payments or
capital gains affects the interest rate of the instrument. Generally instruments that are
tax exempt, are able to offer lower interest rates.

Conclusion

The term structure helps understand the relationship between interest rates and time.
The risk structure helps understand the relationship between interest rates and the
creditworthiness of issuers. Both structures are vital for investors, policy-makers, and
economists in decision-making and forecasting.

Question 4

The Stock Market, the Theory of Rational Expectations, and the Efficient Market
Hypothesis

Introduction

The Stock Market, the Theory of Rational Expectations, and the Efficient Market
Hypothesis (EMH) are interconnected concepts in finance. The stock market, where
stocks are bought and sold, is influenced by investor expectations and the efficient
market hypothesis. Rational expectations theory posits that market participants use all
available information to form their forecasts, while the EMH suggests that stock prices
reflect all available information, making it impossible to consistently beat the market

Key concept

Stock market: The stock market is a platform where buyers and sellers trade shares of
publicly listed companies. It helps companies raise capital by issuing stocks, while
investors gain ownership and potential profits. Prices of stocks fluctuate based on
supply, demand, and market sentiment. Major stock markets include the NYSE,
NASDAQ, and others worldwide. It plays a key role in economic growth by facilitating
investment and wealth creation. Investors can earn returns through capital gains and
dividends.

Theory of rational exceptations: The theory of rational expectations suggests that

individuals and firms use all available information efficiently to predict future economic
conditions. It assumes people do not make systematic errors when forecasting and that
on average, their predictions are accurate. This theory implies that economic policies
are often ineffective if they are anticipated, as people adjust their behavior in response.
It contrasts with adaptive expectations, where past trends influence future
expectations. Rational expectations play a key role in modern macroeconomics,
especially in models like the New Classical and Real Business Cycle theories.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) suggests that
financial markets fully reflect all available information at any given time, making it
impossible to consistently achieve higher returns than the overall market. It implies that
stock prices always incorporate and react to new information instantly. EMH exists in
three forms: weak, semi-strong, and strong, based on the type of information
considered. As a result, active trading or market timing is unlikely to outperform passive
investing in the long run.

EMH is classified into three forms:

Weak Form Efficiency:

All past market data (e.g., prices and volume) is reflected in current prices. Therefore,
technical analysis is ineffective in predicting future prices.

Semi-Strong Form Efficiency:

All publicly available information is reflected in current prices. Fundamental analysis

cannot consistently yield above-market returns.

Strong Form Efficiency:

All information, including insider or private information, is reflected in stock prices. Not
even insider trading can consistently lead to excess returns.

Implications of EMH:

• Investors cannot consistently outperform the market through prediction or

analysis.
• Stock prices follow a “random walk” and only change when new, unpredictable
information is released.
• Passive investment strategies (e.g., index funds) are more effective than active
management

How They Relate to Each Other

The link between Rational Expectations and EMH is foundational:

Rational Expectations assume that investors use all available information to form
accurate forecasts about the future.

EMH assumes that as rational investors act on their expectations, this information is
quickly incorporated into stock prices.

In essence, Rational Expectations provide the behavioral underpinning for EMH.

Without rational expectations, markets could not efficiently incorporate new
information, and the EMH would not hold.

Together, they imply that:

Prices in the stock market reflect the collective expectations of informed, rational
investors. Market movements are a response to new, unpredictable information, making
consistent outperformance unlikely.

Criticisms and Limitations

While both theories have shaped modern financial thinking, they are not without
criticisms:

Behavioral Economics:

Research shows that investors are often irrational and influenced by biases (e.g.,
overconfidence, herd behavior, loss aversion).

Market Anomalies:

Events like speculative bubbles (e.g., dot-com bubble, housing crisis) show that prices
can deviate from fundamental values for extended periods.

Information Asymmetry:

Strong-form efficiency is criticized because insider information is not always reflected

in prices immediately.

Empirical Evidence:

Studies have found certain patterns and anomalies (e.g., January effect, momentum)
that challenge EMH.

Conclusion

The stock market is influenced by a vast array of factors, but the Theory of Rational
Expectations and the Efficient Market Hypothesis provide essential insights into how
investors process information and how prices are determined. These theories suggest
that markets are logical and efficient, and that trying to consistently outperform the
market is futile. However, real-world behavior often diverges from theoretical
predictions, leading to ongoing debates and the rise of behavioral finance as a
complementary approach to understanding markets.