Interest Rates

Interest Rates

Session 2

Interest Rates
Defined

In its simplest definition, it is the cost associated with the use of money. money Alternatively, it is the time value of money; interest rates transforms money-today into moneytomorrow It is the rate at which money grows when invested.

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Role of the Interest Rate;

Role of Interest Rates

A measure to price the funds (or valuation of the financial assets) A factor to bring supply of and demand for funds in balance

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Understanding of

Interest Rates

Interest rate movements affect value of financial assets, and therefore affect the performance of all types of companies. It is critical to understand why interest rates change, how their movements affect performance and how to manage change according to anticipated interest rate movements.
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Interest Rates

The Loanable Funds Theory

Interest Rates
Change?

Why Do

o Determinant of Demand and Supply o Impact of Changes in Money Supply

Market expectations
o Shape of Yield Curve - Expectation Theory of Interest Rates

Other Factors
o Liquidity Preference

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Loanable Funds
Theory

The loanable funds theory is commonly used to explain interest rate movements. LF theory suggests that the market interest rates are determined by the factors that control the control the supply of and demand for the loanable funds The observed level of interest rates results from the market balancing forces of demand & supply for loanable funds.
Interest rates Supply of loanable funds

-6% -5% -4%

Demand for loanable funds Credit or loanable funds in $

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Interest Rate is a function of;

Loanable Fund
Approach

o Supply of Loanable Funds (SSLF) o Demand for Loanable Funds (DDLF).

I = f (SSLF, DDLF)

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SSLF = SSH + SSB + SSG + SSF

SSLF; Supply of Loanable Funds SSH ; Household Supply of loan-able Funds SSB ; Business Supply of Loanable Funds SSG ; Government Supply of Loanable Funds SSF ; Foreign Supply of Loanable Funds Savings of domestic economic units = SSH + SSB + SSG

of Loanable Funds

Supply

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DDLF = DDH + DDB + DDG + DDF

Demand
for Funds

DDLF ;Demand for Loanable Funds DDH ; Household Demand for Loanable Funds DDB ; Business Demand for Loanable Funds DDG ; Govt Demand for Loanable Funds DDF ; Foreign Demand for Loanable Funds

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Changes in Money Supply caused by Households: via savings attitude, propensity to save (differs from country to country) Foreign Parties: via foreign savings Businesses; depending upon cashflows Central Bank: via Monetary Policy Tools i.e.:
o Discount Rates o Reserve Requirements o Open Market Operations
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Changes in

Money Supply

Demand generated by Households: as income increases YH Ability to barrow DDLF-H Businesses: (short term/long term) as r Expected Cash Flow of a project increases NPV more projects get accepted DDLF-B Government: (to cover expenditures) !interest inelastic! BD DDLF-G Foreign Parties: (benefit from interest rate differentials)

Changes in

Demand for Money

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Impact of changes in

Two alternative theories:

o Keynesian Views o Monetarists View

Money Supply

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Keynesian View
Impact on loanable funds

When levels of money supply increases the supply of loanable funds also increases Increase in funds decreases interest rates. Implementation calls for managing interest rate directly.

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Monetarist View

As per this school of thought, changes of money supply affect the level of prices. Increase in money supply, other things held constant, is deemed to increase inflation Consequently, increased inflation leads to increase in observed interest rates.

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Which to follow?

Increase in money supply increases the supply of loanable funds, which causes interest rates to fall. If the affect of money supply is vis a vis the expectation of inflation the inverse is true. Which to follow? In periods of high inflation increases in money supply is most likely to be translated on the expectations of inflation & higher interest rates In periods of ample idle capacity & low inflation rates, increase in Money Supply will tend to reduce interest rates

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Shape of the

Yield Curve

Cost of funds vary with time to maturity of loans This relationship between Interest Rates & the time to maturity is defined by the Yield Curve. Curve The shape of the Yield Curve for any borrower is not constant through time.

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If the interest rates are generally expected to be lower in the future, investors & borrowers will have the following preferences:

Market Expectation

o Investors would prefer to place funds in larger maturities to lock in the current high interest rates o Borrowers would prefer to borrow funds for shorter maturities so that they can refinance at the expected lower interest rates.

Hence:
o In short termsupply of funds < Demand for Funds o In long termsupply for funds > Demand for Funds

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Market Expectation

Consequently in shorter term interest rates tend to increase while interest rates will be lower for larger tenors. This will lead to a downward sloping yield curve.
Interest rates Yield Curve

Time to Maturity

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Expectation Theory of

Interest Rates

Expectations Theory postulates that current interest rates reflect expectations about the future interest rates Under this theory expectations about interest rates is due to expectations about inflation If inflation is expected to rise, the interest rates are expected to rise as well Concept of Nominal and Real Interest Rates
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Interest Rates

Expectation Theory of

Interest Rates

The slope of the yield curve shows the markets expectation about future developments in the interest rates. A downward sloping shows that the market expects future short term interest rates to be lower. Upward sloping YC denotes that the market expects future short term interest rates to be higher.

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Other Factors

If the future interest rates remain at existing levels what will the shape of the yield curve? Upwards sloping Three reasons:
o Liquidity Risk - Liquidity Preference theory o Credit Risk o Compounding

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There are 4 main factors that affect interest rates

Production Opportunities

Summing up..

o The return (or yield) available within an economy from investments in productive (cash-generating) assets.

Time Preference for Consumption

o The preference of consumers for current consumption as opposed to saving for future consumption.

Risk
o The chance that an investment will not provide the expected return.

Inflation
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Economic Growth :
g DDLF r

Impact of inflation :

Key Issues

Inf Fischer Effect r

Impact of budget deficit:

DDLF-G r

Impact of foreign interest rates:

r foreign DDLF-F r

Impact of Money Supply:

SSM SSLF r SSM Inf r
Interest Rates Session 2

Characteristics

Interest Rate

of

In reading interest rate quotations one must be careful to understand the time period involved. Usually these rates are expressed on a per annum basis May differ for different countries. For comparison, it is advisable to convert all figures on a per annum basis Flat interest rate

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Characteristics

Interest Rate

of

The price paid for use of funds can either be paid at the beginning, at the end or at intervals during the life of loan. When interest payment takes place at the beginning of the transaction, it is paid on a discounted basis. basis When the loaned amount along with its interest is paid at the end of loan period, loan is said to be repaid in a balloon payment. payment

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Characteristics

Interest Rate

of

With transactions of more than 1 year, the interest & principal is made on pre-negotiated intervals Because of the various alternatives available to us at the time the principal & interest are due, there will be a difference between the explicit & the implied rate of return. These two may differ depending upon the number of compounding. compounding

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In a Nutshell

The major assumptions/conventions used in calculating interest rates and rates of return are the:
o Per annum o Number of compounds

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Calculating

Interest Rates

Simple Interest Rate Compound Interest Rate Forward Interest Rate

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Simple as the name suggests. Practically used for tenors less than one year.

Simple Interest Rate

FV=PV(1+[i*n/365])
Where
oFV= Future Value oPV= Present Value oi= interest rate/ annum on= number of days

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Interest on interest Primarily used for long tenors.

Compound Interest Rates

PV=FV(1+[i/k])kn
Where
oFV= Future Value oPV= Present Value oi= interest rate/ annum on= period ok= number of compounding

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Forward Interest Rate

Where
oLi = Long Tenor Interest Rate oSi = Short Tenor Interest Rate oLt = Long Tenor oSt = Short Tenor

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