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What is Interest

What is Interest

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Published by Komal Shujaat

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Published by: Komal Shujaat on Aug 19, 2009
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09/25/2010

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MARKET INTEREST RATES

AND ITS IMPLICATIONS ON

INVESTMENT DECISIONS

Table of Contents

pg no.

What is Interest?..................................................................................3 Market Interest Rate…………………………………………………3 Determination of Market Interest Rate………………………………3 Components of Market Interest Rate………………………………...4 Implications of Market Interest Rates………………………………..5 Interest Rate and Risk…………………………………………5 Interest Rate and Bonds……………………………………….6 Interest Rate and Common Stock……………………………...7 Interest Rate and Foreign Exchange………………………….8 Interest Rate and Banks……………………………………….8

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MARKET INTEREST RATES AND ITS IMPLICATIONS ON INVESTMENT DECISIONS
What is Interest?
Interest can be explained from viewpoints of two people: borrower and lender: Borrower: Cost of money for borrowing loan. Lender: Price of money for lending a loan.

Market Interest Rate
Rates of interest paid on deposits and other investments, determined by the interaction of the supply of and demand for funds in the money market is called the market interest rate.

Determination of Market Interest Rates

Interest rates are determined by the interaction of the quantity supplied and the quantity demanded of money. The quantity supplied of money is
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determined by the actions of the central bank and the banking system. Suppose that the interest rate is too high in the sense that the quantity of money supplied is greater than the quantity of money demanded. People will respond by purchasing bonds, in which case money will be reduced. The greater demand for bonds will push interest rates down, towards equilibrium.

Components of Market Interest Rate
Quoted interest rate = k + k* + IP + DRP + LP + MRP Here k = the quoted, or nominal, rate of interest on a given security. There are many different securities, hence many different quoted interest rates. k* = the real risk-free rate of interest. k* is pronounced “k-star,” and it is the rate that would exist on a riskless security if zero inflation were expected. IP = inflation premium. IP is equal to the average expected inflation rate over the life of the security. The expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not necessarily equal to current inflation. DRP = default risk premium. This premium reflects the possibility that the issuer will not pay interest or principal at the stated time and in the stated amount. DRP is zero for some securities, but it rises as the riskiness of issuers increases. LP = liquidity, or marketability, premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a “reasonable” price. LP is very low for some securities and for securities issued by large, strong firms, but it is relatively high on securities issued by very small firms. MRP = maturity risk premium. Longer-term bonds, even Treasury bonds, are exposed to a significant risk of price declines, and a maturity risk premium is charged by lenders to reflect this risk.

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IMPLICATIONS OF MARKET INTEREST RATES
Interest Rate and Risk
The main implication of market interest rate on investment is that the varying interest rates are a risk for investment. The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. Interest rate risk affects bonds more directly than common stocks, but it affects both and is a very important consideration for most investor. Interest rate risk is a systematic risk and is unavoidable. Bond prices are obviously interest rate sensitive. If rates rise, then the present value of a bond will fall sharply. This can also be thought of in terms of market rates: if interest rates rise, then the price of a bond will have to fall for the yield to match the new market rates. The longer the duration of a bond the more sensitive it will be to movements in interest rates. Shares are also sensitive to interest rates, again it is obvious that if interest rates change (and other things remain equal, which the Fisher effect suggests may not be the case) then DCF valuations will fall. In addition, the profits of highly geared companies will be significantly affected by the level of their interest payments. Banks can also have significant interest rate risk: for example they may have depositors locked into fixed rates and borrowers on floating rates or vice versa. Other Effect of an Increase in Market Interest Rates. 1. Cost of Borrowing is more expensive. If borrowing is more expensive consumers will take out fewer loans. Firms will borrow less. Therefore consumer spending and investment will fall (or increase at slower rates). 2. Mortgage and loan repayments increase. Higher mortgage payments reduce disposable income so consumer spending will be lower.
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3. Return on savings increase. Saving is more attractive, so this will also reduce consumer spending.

Bonds and Interest Rate
The price of a typical bond changes inversely to changes in interest rates or yields. In other words, when interest rates increase, bond prices fall and vice versa. Since bond prices fluctuate relative to interest rates, among other things, bond investors would be wise to incorporate interest rate risks into their portfolios’ performance measurements. Bond prices are influenced by the yield they pay and the rate of interest investors can earn elsewhere. If interest rates are high, savings accounts will pay more and bonds, therefore, become less attractive. Bond Features Impacting Interest Rate Fluctuations How sensitive a bond’s price is to interest rate fluctuations depends on certain characteristics of the bond, such as maturity, coupon rate and existence of embedded options. Maturity: The longer the bond’s maturity, the greater the bond’s price sensitivity to interest rate fluctuations. Coupon rate: The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates. The price sensitivity of Zero-coupon bonds is the greatest when compared to coupon-bearing bonds of the same maturity and trading at the same yield. Embedded options: If a bond is callable prior to its maturity date at the discretion of an issuer, this bond has an embedded option. But this particular option is not favorable to an investor because if interest rates decline, the issuer may find it beneficial to call the bond prior to its maturity date in order to refinance the debt issue at lower interest rates, even if it means paying a higher price. Unfortunately, the investor has no say in this, and therein lays the interest rate risk associated with a bond with embedded options.

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Stock and Stock Exchange and Interest Rates
Rising and falling interest rates offer a special risk to stock investors. Historically, rising interest rates have had an adverse effect on stock prices which has resulted in lower stock index. During 2008, the LSE-25 index declined by 20% on a year-on-year basis due to higher inflation and higher interest rates. Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls. The financial health of the customers directly affects the company’s ability to grow sales and earnings. High or rising interest rates can have a negative impact on any investor’s total financial picture. An investor has also to struggle with burdensome debt, such as a second mortgage, credit card debt, or margin debt. He may sell some stock in order to pay off some of his highinterest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices. So, stock is also affected indirectly by the interest rates changes. Futhermore, higher interest rates make it relatively more attractive to save in banks rather than invest in the stock market. Shares usually have an inverse relation with interest rates changes. But for those industries that benefit from high interest rates have a positive relation with interest rates like that of banks. Banks usually profit from high interest rates. So, price of their shares grow when interest rates are high. Impacting investors’ decision-making considerations When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes: o Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Interest rate changes affect some industries more than others.

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o Investors who favor increased current income (versus waiting for the

investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher rate of return. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit. Sometimes there is a little move in share prices when, for example, interest rates shift. This is because investors try to anticipate what is going to happen in the next few months and try to move their portfolios in or out of these stocks before the rest of the market catches on. But most of the times, of course, these expectations can be wrong and if this happen, markets can move very sharply.

Foreign Exchange Rate and the Interest Rates
An increase in interest rates makes a currency more attractive. This causes hot money flows into an economy causing an appreciation. Similarly a cut in interest rates will often cause depreciation in the currency.

Banks and Interest Rates
Banks usually profit from high interest rate. However, changes in interest rates affect a bank's earnings by changing its net interest income and the level of other interest sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change. Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks. Banks face four types of interest rate risk: Basis risk The risk presented when yields on assets and costs on liabilities are based on different bases, such as the base rate provided by SBP versus the Pakistan market interest rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.

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Yield curve risk The risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses. Repricing risk The risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate. Option risk It is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with relatively more loans based on prior, lower interest rates. Option risk is difficult to measure and control.

Hedging Interest Rate Risk
Interest rate risk can be hedged using swaps and interest rate based derivatives. Ways in which interest rate risk can be controlled include: 1. investment in floating rate rather than fixed rate securities 2. investing only in securities due to mature in the short term 3. buying interest rate derivatives.

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Calculating Interest Rate
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
1. Marking to market, calculating the net market value of the assets and

2. 3. 4. 5. 6.

liabilities, sometimes called the “market value of portfolio equity” Stress testing this market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel Calculating the Value at Risk of the portfolio Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

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