DIFFERENCE BETWEEN INTEREST RATES AND CAPITAL GAIN

-Both interest and capital gain are a percentage of the principal.

-Interest rate is the measurement of interest income, yields, dividend,income, or profit.

-Capital gain is the increase in value.

To illustrate, let us take an investment in bonds of PHP 10 000 with an interest rate of 10% and a market
value at the end of the year after acquisition of PHP 11 000.

Interest rate is computed as r = I/P

Where r = interest rate

I = Interest received for the period
p = principal or price of the bond
Interest rate = php 1,000/ php 10,000
= 10%

Capital Gain is computed as : cg = MV-P/P

Where cg = capital gain

MV = Market Value

P = Principal

MV-P = change in value/Gain in peso

= 11,000 – 10,000 = _1,000_

10,000 10,000
= 10%
Therefore
ROR = 10% (r) + 10% (cg) = 20%

If the bond has decreased in value from 10,000 to 9,000, the second part would give us:
9,000 – 10,000 = (1,000) = (10%)
10,000 10,000
ROR = 10% (IR)+ (-10%) = 0%
The investor earned 10% interest , but lost 10% due to the decrease in value of the bonds of 10%,
making the net yield to the investor equal to zero (0%). What the investor earned in terms of interest
was entirely lost, due to decrease in value.

INTEREST RATES AND THEIR ROLE FINANCE

 Finance deals with funds, and funds generally denote money.
  The earnings on money lent and the cost of money borrowed are expressed as a percentage of
the principal amount of money lent or borrowed are called interest rate.
 Changes in interest rates have implications for a multitude of phenomena in the business and
economic world.
 Central banks use interest rates to control money supply, demand for money, reserve
requirements, and other tools to maintain a healthy and stable economy.

INTEREST RATES AND THE ECONOMY

Interest rates have the following important roles in the economy:
1. Ensure that current savings will flow into investment to promote economic growth.
2. Ration the available supply of credit to provide loanable funds to those investments projects
with the highest expected returns.
3. Bring into balance the supply of money with the public’s demand for money.
4. Act as an important government tool through its influence on the volume of savings and
investment.

INTEREST RATES THEORIES

1. Classical Theory/Fisher hypothesis
2. Loanable Funds Theory
3. Liquidity preference Theory
4. Rational expectations Theory

CLASSICAL THEORY
This theory posits that the rate of interest is determined by two factors:
1. Supply of savings
2. Demand for investment capital
-Savings are generally carried on by individuals and families (households) and for these households, they
are simply abstinence from consumption spending.
Comsumption spending means spending for both durable and non-durable goods and services.
Savings are equal to income minus consumption expenditures.

-Classical theory assumes that individuals have a definite time of preference for current over future
comsumption. It is assumed that a rational individual will always prefer current enjoyment of goods and
services over future enjoyment.
-Substitution Effect is substituting savings now for more consumption in the future.

LOANABLE FUNDS THEORY

 Often used for forecasting interest rates
 Households, businesses, and government are the borrowers and lenders at one time or another.
Households invest whatever savings they have from their incomes. They also borrow when their
incomes are insufficient to support their needs, especially for unforeseen events such as death or
calamities. They borrow for housing, educational, funeral, and hospital needs. They also deposit money
in the bank and invest in other financial instruments that they can afford.

Businesses are active participants in the financial markets borrowing from the market for inventories ;
working capital needs; purchase of property, plant, and equipment; and other projects by issuing stocks
and bonds

Government borrow from the financial markets by issuing government secuties like T-bills, T-notes, and
T-bonds when they have deficits. But the government also buys financial securities from the financial
markets whenever they have surplus units.

Liquidity preference Theory

 This theory stipulates that the interest rate is determined in the money market by the money
demand and the money supply
 Investors purchase securities when interest rates are high for the simple reason of yield,
increasing the supply of funds in the financial system.
 They shy away from buying securities when interest rates are low, thereby reducing the supply
of money in the financial system
 The government acts as the regulator.

Example: a three-year Treasury note might pay a 2% interest rate, a 10-year treasury note might pay a
4% interest rate and a 30-year treasury bond might pay a 6% interest rate. For the investor to sacrifice
liquidity, they must receive a higher rate of return in exchange for agreeing to have the cash tied up for
a longer period of time.

3 Motives why people hold their money

Transaction motive - having sufficient cash on hand for basic day-to-day needs.
Precautionary motive - event that is unexpected
Speculation motive - tying up investment capital

Rational expectations Theory

It is based on premise that the financial markets are highly efficient institutions in digesting new
information affecting interest rates and security prices.

 Individuals use their ability to rationalize when making decisions.

 People learn from past mistakes.
 Individuals create expectations based on all available information.
 Individuals create expectations based on all available information.