Interest Rates Structure,

determinants, development of BLR

and its computation
Definition:
a) the price of borrowing money
b) amount charged by lender to borrower for
borrowing a sum of money expressed as percentage
of sum borrowed
 To a lender (surplus unit) – the return earned for
parting with his funds over a certain period of time
 To a borrower (deficit unit) – the price to pay over a
specific period of time (the interest expense)
 Nominal rate is the rate offered and quoted
to customers without taking into account the
inflation rate
 Real rate is the rate after considering inflation
rate
 Simple/Approximate formula:
 Real Int. rate = Nominal Int. rate – Inflation rate
(NR) (IR)

Exact Formula:
 Real interest rate = 1 + NR - 1
1 + IR
 Simple Interest rates = pxrxn
365x100

where p = principal amount

r = nominal interest rate
n = no. of days
a. Describe the methods of calculating the
interest – example simple interest;
b. Describe the behavior of interest rate –
example fixed rate or variable rate (pegged
with BLR or KLIBOR)
c. Annual Percentage rate (APR)
 Quotation based on applying an interest rate
to the daily loan balance outstanding during a
specified period;
 Quoted in terms of annual rate (eg. 12 %) or
daily periodic rate (eg. 0.032877)
 Fixed rate - only one interest rate quoted
through out the life of the loan
 Same monthly payment
 It is used because of stable income of
customers and easy to budget
 However exposed banks to interest rate risk,
therefore use variable rate; how?
 Variable rate or floating rates are rates pegged
against BLR, KLIBOR or multi-tiered rates
 Rates changes with the pegged rates
 Protect both borrower and lender against
fluctuations
 Eg. When BLR increases, rates on variable loan
increases and is reflected in higher monthly
payments or increase in number of payment
 Minimises interest rate risk but may increase credit
and collateral risk; how?
 Sometimes banks quote both fixed and variable on
a particular loan
 Gap between fixed and variable increases when
interest rates rise and narrow when rates drop
 Fixed rates  credit cards, car loan or other hire
purchase
 Variable rates  property-based lending and
business loans
  Total cost of borrowing expressed as a percentage; common language to
describe cost of borrowing
 Formula : 2NF (300C + NF)
2

2N F + 300C (N + 1)
Where N = number of instalments
C = no. of instalments to be paid in one year
F = amount determined by 100C x T
NxA
where T = total amount of predetermined term charges
N = no. of instalments
A = amount financed
 BLR is a rate used by commercial banks and finance
companies as a basis to quote for lending and
advances facilities offered to customers
 Generally, it is derived by taking into account the
funding cost. administrative cost and an imputed
profit margin
 Previously, the funding cost is represented by the 3-month
KLIBOR average
 later in 1998 in view of the economic situation the formula
was revised to be based on ‘intervention rate’
 Old framework (for commercial bank):
BLR = (Average KLIBOR* x 0.8) + 2.5%
1 – SRR
* Intervention replaced KLIBOR in 1998
 Currently each bank calculate its own BLR based on cost
structure and business strategies after considering the OPR
(more efficient pricing)
 any changes in OPR will give impact to the level of BLR of
banks
 BLR is based on Overnight Policy Rate (OPR) which
in turn is based on interbank rate
 Thus, OPR is the primary reference rate in
determining other market rates
Interbank rates OPR

BLR
Lending rates
(Rates quoted to customers housing
loan/automobile loan/business loan)
 Higher actual or expected inflation, higher
will be the level of interest rates (positive
relationship)
 Investor needs to earn higher return to
compensate for the increased cost of
foregoing consumption of goods/services
today and buy more highly priced of these
goods/services in the future
 The rate that would exist on a security
without any expected inflation over the
holding period
 It is the percentage change in the buying
power of a dollar
 It measures consumer’s relative time
preference for consuming today rather than
later ; the higher the preference to consume
today the higher will be the real interest rate
 The risk that the issuer will not pay the
interest and principal on a timely basis
 default risk the interest rate demanded
by investor to compensate for the risk
exposure
 The risk that the securities will be easily sold
at the expected price (without reduction in
value)
 Highly liquid assets carries lowest interest
rates
 For Illiquid assets, investors will add a
liquidity risk premium
 Special provisions or covenants in the contract
of an issuance of a security will effect interest
rates; examples callability, convertibility,
taxability
 Thus, if the bond is tax free, the interest rate of
that bond is lower compared to a taxable bond
 Provisions such taxability and convertibility
leads to a lower rates; but if provisions is to the
benefit to the issuer such as callability the
interest rates will bi higher
 Refers to the length of time the security will
mature and this affect interest rates  the ‘term
structure of interest rates’ or ‘yield curve’
 The change in required interest rates as maturity
changes is called ‘maturity premium’
 The ‘maturity premium’ can be positive (an
upward sloping yield curve), negative
(downward sloping curve) or zero ( a flat yield
curve)