INTEREST RATES

• The interest rate is the amount charged on top of the principal by a lender to a
borrower for the use of assets
• The interest rate is defined as the proportion of an amount loaned which a lender
charges as interest to the borrower, normally expressed as an annual percentage.
• The Annual interest rate is the rate over a period of one year.
• Other interest rates apply over different periods, such as a month or a day.
• The borrower wants, or needs, to have money sooner rather than later, and is willing
to pay a fee which is the interest rate for that privilege.
TYPES OF INTEREST RATES
• A variety of short term, medium term and long term interest rates exists in the
financial markets such as:
1. CEILING RATE: The ceiling rate refers to the maximum rate of interest fixed by the
authorities on different financial claims. In India, the government and the RBI fixes
ceilings on securities.
2. COUPON RATE: The coupon rate, also known as the ‘Bond Rate’ which is the rate of
interest stated and paid on the face value of the Bond or Debenture
3. YIELD: The term ‘Yield’ represents the rate of interest which equals the present value of
the future cash flows generated by an investment.
1. Running yield on bond (also known as Income yield/market yield/current yield) is
an annual interest payment as a proportion of the market price of the bond.
2. ‘Yield to maturity or Redemption yield is the annual interest payment plus average
appreciation or depreciation as a proportion of the redemption value of the bond.
(debentures)
3. Dividend yield and earnings yield are concepts usually in evaluating investment in
ordinary shares
Determinants of interest rates
• When other things being equal(Ceteris Paribus), the price of a bond falls when the
required rate of returns rises and vice versa.
• The required rate of return has an important influence on the bond price
• The interest rate on a bond is determined by four factors or variables:
1. Short term risk free interest rate
2. Maturity premium
3. Default premium
 4. Special feature
1. Short-term Risk-free Interest Rate:-
• Short term interest rate is the yield on a one-year government security, say a 364
day Treasury bill.
 Govt. securities are risk free because as it is not expected to default on its
obligations
 Short-term risk free interest rate = Expected real rate of return + Expected inflation
2. MATURITY PREMIUM
 It represents the difference between the yield to maturity on a short-term (one
year) risk-free security and the yield to maturity on a risk-free security of a longer
maturity
 To know how the yield to maturity is related to the term to maturity we have to
understand yield curve.
 Yield curve ordinarily slopes upward because investors expect a higher yield for
making investment over a longer period of time.
 Which means maturity premium increases with increase in time
3. Default premium
 A default premium is an additional amount that a borrower must pay to
compensate a lender for assuming default risk
 Default Risk is the risk that a lender undertakes in the case of borrower defaulting to
repay the debt obligation
 All companies or borrowers indirectly pay a default premium
 The default premium increases with default risk
4. Special features
 The Short-term risk-free interest rate, maturity premium and Default premium
would determine the interest rate on a Plain Vanilla Bond, i.e. a bond which pays a
fixed amount of interest (I) Periodically, and Certain principal sum (P) at a given
maturity date.
 Bonds often have some special features. They may have
1. Call feature:- which entitles the issuer to prematurely redeem them
2. Put feature:- which gives the investor the option to redeem them prematurely.
3. Or a combination of a call and put feature; they may be convertible, partly or fully,
in to equity shares on certain terms;
 4. They may carry a floating rate of interest, rather than a fixed rate of interest;
5. They may be Zero coupon bonds issued at Deep discount (carrying a low rate of
interest relative to prevailing market rates and issued at a discount to their
redemption value) and Redeemed at Par (Redeeming the same bond at par means
redeeming the bond at the face value) so on and so forth.

Market segmentation theory

• Market segmentation theory states that long- and short-term interest rates are not
related to each other because they have different investors
• The preferred habitat theory is related to the market segmentation theory, it states
that investors prefer to remain in their own bond maturity range due to
guaranteed yields.
• Any shift to a different maturity range is perceived as risky
• It also states that the prevailing interest rates for short, intermediate, and long-
term bonds should be viewed separately like items in different markets for debt
securities
• This theory's states that Yield curves are determined by supply and demand forces
within each market/category of debt security maturities and
• The yields of one category of maturities cannot be used to predict the yields for a
different category of maturities
• The market for each segment of bond maturities consists mainly of investors who have a
preference for investing in securities with specific durations: short, intermediate, or long-
term

• The theory is partially based on the investment habits of different types of

institutional investors such as banks and insurance companies
• Banks generally favor short-term securities, while insurance companies generally
favor long-term securities as a general trend of investment

PREFERRED HABITAT THEORY

• The preferred habitat theory was introduced by Italian-American economist Franco
Modigliani and the American economic historian Richard Sutch in 1966
• Investors prefer shorter maturity bonds over longer-term ones
 • Investors are only willing to buy outside of their preferences only if enough of risk
premium (higher yield) is attached to those bonds
• The preferred habitat theory states that bond market investors demonstrate a
preference for investment timeframes, and such preference dictates the slope of
the term structure(yield curve).
• Bond market investors require a premium to invest outside of their ‘Preferred
habitat’
• For example, an investor favoring long-term bonds will only invest in long-term
bonds if they yield a significantly higher return relative to short-term bonds and vice
versa
• Therefore, investor preferences that favor short-term bonds over long-term bonds
would give rise to the standard upward sloping yield curve and
• Investor preferences that favor long-term bonds over short-term bonds would give
rise to the inverted yield curve. Since the investors prefer shorter maturity bonds
over longer-term ones
• Thus, to encourage investors to buy maturities outside their preference, prices
must include a risk premium/discount
• Investors are only willing to buy outside of their preferences if enough of a risk
premium(higher yield) is attached to those bonds

Preferred habitat hypothesis

• If current interest rates are high, investors expect interest rates to drop in the future.
• For this reason, the demand for long-term bonds will increase since investors will
want to lock in their investments with the current prevalent higher rates of interest
• Since bond issuers attempt to borrow funds from investors at the lowest cost of
borrowing possible, they will reduce the supply of these high interest-bearing bonds
• The increased demand and decreased supply will push up the price for long-term
bonds, leading to a decrease in long-term yield, which will therefore be lower than
short-term interest rates
• The opposite of this phenomenon is theorized when current rates are low and
investors expect that rates will increase in the long term
Importance of interest rate
• Interest rates are very significant to the economy of the country. The following
points will help you to understand the significance in a better way:
1. Interest rate is related to the general price level . They are positively co-related.
Hence, adjustment and re-adjustment of interest rates is very significant for the
economy as a whole.
2. There is positive relationship between interest rate and money supply too. Keynes
opined that an increase in money stock may tend to lower the interest rates and vice
versa.
3. Open market purchase by the monetary authority tends to raise security prices and
lower their yields.
4. In countries like India there are a number of interest rates apart from the general
level of interest rates which are conversional known as “differential interest rates”.
5. These interest differentials policies are adopted by the authority with a view to
achieve the goal of social welfare.
6. Interest rate is also a tool for controlling inflation and low interest rate policy can
cause favorable conditions for further inflation
7. The rate and composition of savings is affected by the interest rate.
8. High interest rates in deposits encourage savings which is desirable in a capital
scoring economy like India whereas Low interest will work as a Disincentive to Save.
9. Hence, there is a significant relationship between interest rates and total savings,
financial savings, household savings, and corporate savings.
10. Interest rates structure influence the degree of social and mass welfare of an
economy.
A reduction in interest rates on bank deposits, small savings, provident fund and other debt
instruments harm the interests of low income group, old, weak, poor, disadvantaged who
are in

INTERDEPENDENCE OF MARKETS
• Interdependence can be defined as the relationship between two or more parties
that depend on each other for survival.
• Every part needs to contribute something to the other party to survive.
• Market interdependence is when the movement of one market is affected by the
movement of another market.
• For example, - a drop in the value of the dollar vs other currencies, can cause a rise
in the price of oil in dollars, since, oil is a dollar denominated asset.
• In this example, the oil market is dependent on the foreign exchange market
• The financial sector reforms in India have brought in wide ranging changes in the
financial markets in India
• Beginning of the nineties, many barriers that had hitherto restricted the flow of
funds across the different financial markets have been removed (LPG)
• The markets thus affected are Call money, government bonds, foreign exchange
and stock markets etc
• The investor base in each of the markets has also been expanded considerably
• A key objective of the financial sector reforms in India has been to increase the
extent of interdependence between the different financial markets in India
• There are substantial phase differences between the financial markets in India as
compared with the US financial markets
• Even when it comes to the volatility level(instability in one market affects other
markets) the interlinkages are greater in the US than in India
• Since 1991, there has been increased degree of interdependence of the Indian stock
market with the US stock market
• There are Unidirectional Volatility Spillovers from the US stock market to the stock
market in India
• The cross - market volatility linkages that have effects on the investment and
regulatory policies of the dependent country markets
• To decide on the volatility margins to be imposed on a particular market, regulatory
authorities need to consider the volatility spillovers from the other markets.
• Investors should survive in these cross-market volatility linkages while formulating
their risk management policies
• By increasing the access of market players to multiple markets, it is possible to
increase the degree of interdependence between these markets
• This study has implications on the monetary policy of the Reserve Bank of India
• It points out that the low degree of interdependence between the financial markets
in India is not conducive to efficient monetary policy transmission and resource
allocation mechanisms.
• A key objective of the financial sector reform process in India has been to increase
the extent of interdependence between the different financial markets in India.
• Past research elsewhere has extensively studied the interdependence across the
stock markets, the money markets, and the foreign exchange markets of different
countries.

Interest Rates and Rational Expectations

• The idea of rational expectations was first developed by American economist John F.
Muth in 1961. It was popularized by economists Robert Lucas and T. Sargent in the
1970s
• Rational expectations theory states that individuals make decisions based on the
best available information in the market and learn from past trends /mistakes
• It is a tool to guess for the future and helps in making decisions. Generally peoples
expectations are right, but they can sometimes be wrong as well.
ASSUMPTIONS:

 With rational expectations, people always learn from past mistakes

 People’s forecasts are unbiased, and they use all the available information and
knowledge of economic theories that they possess to make decisions.

 People understand how the economy & government policies work and affect
macroeconomic variables such as Price level (inflation), level of Unemployment
and Aggregate Output(National Income)

 Economists use this theory to explain the anticipated economic factors such as
inflation rates and interest rates.

 FOR EXAMPLE, if past inflation rates were higher than expected, then people might
consider that future inflation also might exceed expectations.

 Since Expectations and Outcomes influence each other, there would be continuous
feedback flow from past outcomes to current expectations.

 The theory also believes that because people make decisions based on the available
information at hand combined with their past experiences. Most of the times their
decisions will be correct and people adjust their forecasts to conform to this stable
pattern.

 The theory does not deny that people often make forecasting errors, but it does
suggest that errors will not repeat persistently
• The Rational expectations theory comes in two versions; 
 1. STRONG VERSION: - In this version it assumes that people have the ability to make
rational decisions because they have access to available information. The decisions
they make are based on this information. 
2. WEAK VERSION:- In this version people do make a decision based on their limited
knowledge simply because, they lack time to get hold of all the information that
they require.
• When the Federal Reserve Bank of USA decided to use a Quantitative policy to help
the economy ease out of the 2008 financial crisis, it set very high expectations for
the country and reduced interest rates for more than seven years. As a result of this
move, people began to believe that interest rates would remain low in future also.
• Expectations do not have to be correct to be rational; they just have to make logical
sense given what is known at any particular moment.
• Using this idea/theory famous British Economist “J.M Keynes” assigned people’s
expectations about the future—which he called as “Waves Of Optimism And
Pessimism”— which plays an important role in determining the business cycle
fluctuations in the economy
• The theory is used in business cycles and finance as a foundation for the Efficient
Market Hypothesis (EMH). 

Efficient market HYPOTHESIS

• The efficient market hypothesis states that when new information comes into the
market, it is immediately reflected in stock prices and thus neither technical nor
fundamental analysis can generate excess returns.
• It is based on the assumption that prices of securities in financial markets fully
reflect all available information and from that information, the investors neither
can gain nor lose
• Using this theory, the investment analysts study the behaviour of stock prices
• An efficient market is one in which the market price of a security is an unbiased
estimate of its intrinsic value (is a measure of what an asset is worth).
• Market efficiency does not imply that the market price equals intrinsic value at
every point in time.
• The price can deviate from the intrinsic value and it states that the best guide to
future asset values is present asset values
• This is because investors have a profit incentive to look at all possible data and
information
 • If a stock is undervalued or overvalued, there is a profit incentive to buy/sell – to
move the asset closer to its actual value
The efficient market theory is described in three forms:
1. Weak-form efficiency:- states that past prices, historical values and trends can’t
predict future prices. It states that stock prices reflect all current information.

2. Semi-strong form efficiency:- it contends that a security’s price movements are a

reflection of publicly-available material information. It suggests that fundamental
and technical analysis are useless in predicting a stock’s future price movement.

3. Strong-form efficiency:- Prices reflect both publically available information and

inside information. In this type of market, neither technical analysis nor fundamental
analysis nor inside information can help predict future price movements.

 According to this theory, the change in prices of stock show independent behavior
and are dependent on the new pieces of information that are received.

 For example:- if a stock is selling at Rs.25 per share based on existing information
known to all investors, suppose a news of a textile strike comes out it will bring
down the stock price and the value goes down to Rs.20 the next day, the value
goes down further to Rs.10 on the subsequent day.

 The first fall in price from Rs.25 to Rs.20 per share was caused due to the
information about the strike and the second fall in the price from Rs.20/- to
Rs.10/- was due to the outbreak of additional information on the type of strike.

 This response makes the movements of price independent of each other.

 According to this theory, the financial markets are so competitive that there is
immediate price adjustments.

 This is as a result of good communication system through which information can be

distributed almost anywhere in the country

 It is this speed of spreading of information which determines the Efficiency of the

market

 This theory also states that rapid shift to a new equilibrium level whenever new
information is received is called the Random Walk theory

 The basic essential fact of the Random Walk Theory is that information on stock
prices is immediately and fully disseminated/spread so that other investors have
full knowledge of the information

 This response makes the movements of price independent of each other

 The Random Walk theory is based on the efficient market hypothesis which is
supposed to take three forms
1. WEAK FORM:
• The weak form of the market says the past prices do not provide help in giving any
information about the future prices.
• Here short –term traders also would be in a position like any other another investor
who adopts the approach of buy and hold strategy
2. SEMI-STRONG FORM
• this form of market reflects all information regarding historical prices as well as all
information about the company which is known to the public.
• According to this theory any analyst will find it difficult to make a forecast of stock
prices, because he will not be able to get superior and consistent information of any
company continuously.
• It maintains that as soon as the information becomes public, the stock prices change
and absorb the full information
3. Strong form
• The strong form suggests that it is not useful to any investor or analyst to make any
future forecast of prices because he can never make any returns which are superior
to others consistently
• Here each investor is fully aware of the new pieces of information in the market and
so even if the analyst has inside information he cannot continuously earn superior
investment returns
• The strong efficient market hypothesis is not found to be fully acceptable
Efficient market HYPOTHESIS – conclusion
 • Finally the efficient market model acknowledges that the stock exchange has many
imperfections and all information may not be immediately reflected in stock prices
due to delays in communication.
• It is possible to have some profit above the normal profit by developing a kind of
trading strategy.

Expectations Theory
• Expectations theory attempts to predict what short-term interest rates will be in
the
future based on current long-term interest rates 
• An investor earns the same interest by investing in two consecutive one-year bond
Versus investing in one two-year bond today.
a. When the yield curve is upward sloping, it implies that market participants expect
interest rates to rise in the future
b. Downward slope implies the expectation of interest rates to fall in future.
c. Horizontal line suggests that interest rates are not expected to change in the near
future
• The expectations theory aims to help investors make decisions based upon a
forecast of future interest rates.
• The theory uses long-term rates, typically from government bonds, to forecast the
rate for short-term bonds.
• In theory, long-term rates can be used to indicate where rates of short-term bonds
will trade in the future.
CALCULATING EXPECTATIONS THEORY
• Let's say that the present bond market provides investors with a two-year bond that
pays an interest rate of 20% while a one-year bond pays an interest rate of 18%
• The expectations theory can be used to forecast the interest rate of a future one-
year bond
• The first step of the calculation is to add 1 to the two-year bond’s interest rate. The
result is 1.2.
• The next step is to square the result or (1.2 * 1.2 = 1.44).
• Divide the result by the current one-year interest rate 18% and add 1 ((1.44 / 1.18)
+1 = 1.22).
• To calculate the forecast for one-year bond interest rate for the following year,
subtract 1 from the result (1.22 -1 = 0.22 or 22%).
• In this example, the investor is earning an equivalent return to the present interest
rate of a two-year bond. If the investor chooses to invest in a one-year bond at 18%,
the bond yield for the following year’s bond would need to increase to 22% for this
investment to be advantageous than the two year bond interest of 20%

Expectations Theory— (continued)

• If expected future short-term rates are above the current short rate then the yield
curve will be Ascending, i.e., the rate of a bond with 2-year maturity will be above
the rate on the bond with a one-year maturity.
• If expected short rates are below the current short rate yield curve will be
Descending. Yield curve will be flat if future short rates are expected to be the same
as the current short rate.
• You can derive a return over a short holding period by purchasing a longer maturity
and selling it at the end of the short holding period.
• You will be indifferent between long-term and short-term maturities only when their
net rates of return are equal for each holding period
• This theory is also called “predominant opinion hypothesis”.