Interest Rates

3
Syllabus
A) Cost of Money & Factors Affecting Cost of
Money
B) Interest Rate and Component of Interest Rate
C) Term Structure of Interest Rates and Yield
Curve
D) Other Factors Affecting Interest Rates

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Concept of Cost of Money
Factors that determines the cost of Money are:
CAPITAL is allocated
-Production Opportunities
Higher
Companies raise the productionfrom
Capital market system
opportunities, higher will be
the demand for money
in two main form DEBT through transfer
and higher will beofthe
fund
cost of
money from surplus segment to
& EQUITY
-Time Preference deficit
for Consumption
segment of the
High consumption leads
society saving; low saving
to low
leads to low supply of money which increases the
cost of Money
The Demand -Risk
for & Supply of money thus sets the price at which
the funds are Iftraded,
the investor
whichpresumes
is knownhigh
as risk
costinof
anmoney
investment,
termed as
s/heofdemands
Interest in case high rate
Debt Capital andofDividend
return leading to increase
in case of Equity
in cost of Money
Capital
-Inflation
High inflation decreases the purchasing power of
money, so as to compensate the loss caused by
decreased value of money, lender/investor higher
rate of return
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Interest Rates & its
Determinants
Interest rate is the cost paid by the user(deficit party) to the
supplier(surplus party) of the fund against the mutually agreed terms
and conditions.

In a free market economy, the demand for and the supply of the fund
determines the interest rates. Higher the demand for the fund, higher
will be the interest rates and higher the supply of the fund, lower will be
interest rate

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Determinants of Interest Rates
Nominal (Quoted) Interest Rate (K)=
K*+IP+LRP+DRP+MRP Or Krf+LRP+DRP+MRP
Where,
K The Nominal/Quoted rate of Interest in a given security

K* Real Risk Free Rate of Interest. Exist in a riskless security with no

expected inflation

IP Average Expected Inflation Rate over the life of Security. Higher the
inflation rate, higher will be the rate of interest

LRP This is charged by lenders to reflect that some securities cannot be

converted to cash on short notice at a “reasonable” price
DRP This reflects the possibility that the issuer will not pay the promised
interest or principle in the stated time period

MRP This reflects the charges imposed by the lenders for not being able to
use the fund for a longer period of time.
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 Determinants of Interest Rates
Note:
Nominal Risk Free Rate of Interest (Krf)= K*+IP
It is a quoted rate on a risk free security which is very liquid and is free
of most type of risk. (IP is included)
Government Securities (like T-Bill/T-Bond) carries Nominal Risk Free
Rate of Interest and are free from other kind of risks (LRP & DRP).
However they are imposed with some portion of Maturity risk premium

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 Term Structure of Interest &
Yield Curve
Term Structure of interest rates is
the relationship between yield to
maturity and time to maturity for
bonds & the graphical
representation of the relationship
between yield to maturity and time
to maturity gives the yield curve

The shape of Yield Curve could be upward sloping,

downward sloping and humped depending up on the
expected inflation and demand-supply condition.
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-An upward sloping yield curve is considered as Normal Yield Curve,
because in general the long term interest should be higher than short term
interest. The reason for high interest rate in long run are
i) Higher expected inflation premium in future (High Inflation Premium)
ii) High interest rate risk associated with long term security (High MRP)
iii) Less convertibility of security having longer maturity (LRP)

-Conversely if the market expects that the future rate of inflation will
decrease (case of recession), the yield on long term bond will be lower than
the yield on short term bond, resulting in downward sloping Yield Curve

-A humped yield curve occurs when the long term and short term yields are
equal but mid term yields vary from those of long and short term yields

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The Expectation Theory
 The expectation theory assumes that the investors determine the
bond’s price and interest rate based on their expectation of future
inflation rates. Higher the expected inflation rates, higher will be the
interest rate.
 In expectation theory, market interest rate are determined
considering only the treasury securities and it is assumed that all
treasury securities fall in same risk classes and thus there is no
maturity risk premium
 In the absence of maturity risk premium, the long term interest rate
is simply the average of current and future short term interest rates
 The expectation theory however fails to explain why the yield curve
is upward sloping.

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