Chapter Three: INTEREST RATES IN THE FINANCIAL

SYSTEM

INTEREST RATES DETERMINATION AND STRUCTURE

The rate of interest

Interest rate is a rate of return paid by a borrower of

funds to a lender, or a price paid by a borrower for a
service, or the right to make use of funds for a
specified period. Thus, it is one form of yield on
financial instruments.
 Cont’d
• There is interest rate at which banks are lending (the
offer rate) and interest rate they are paying for deposits
(the bid rate). The difference between them is called a
spread.
• The spread between offer and bid rates provides a
cover for administrative costs of the financial
intermediaries and includes their profit. The spread is
influenced by the degree of competition among
financial institutions.
 Con’d
• In the short-term international money markets, the
spread between offer and bid rates is lower if there is
considerable competition.
• on the other hand, the spread between banks borrowing
and lending rates to their retail customers is larger in
general due to considerably larger degree of loan default
risk.
• Thus, the lending rate (offer or ask rate) always
includes a risk premium.
 Cont’d
• Risk premium is an addition to the interest rate
demanded by a lender to take into account the risk
that the borrower might default on the loan entirely
or may not repay on time (default risk).
 Cont’d
• Factors that determine the risk premium for a non-
Government security, as compared with the
Government security of the same maturity are:
1. The perceived credit worthiness of the issuer,
2. provisions of securities, such as conversion provision, call
provision, put provision

3. Interest taxes, and

4. Expected liquidity of a security’s issue.

 Cont’d
• In order to explain the determinants of interest rates
in general, the economic theory assumes there is
some particular interest rate, as a representative
of all interest rates in an economy.
• Such an interest rate usually depends upon the topic
considered, and can be represented by e.g.
1. interest rate on government short-term or long-term debt,
2. the base interest rate of the commercial banks, or
3. a short-term money market rate
 Cont’d

• In such a case it is assumed that the interest rate

structure is stable and that all interest rates in the
economy are likely to move in the same direction.
• Interest rate structure is the relationships between
the various rates of interest in an economy on
financial instruments of different lengths (terms) or
of different degrees of risk.
 Cont’d
• The rates of interest quoted by financial institutions
are nominal rates, and are used to calculate interest
payments to borrowers and lenders.
• The loan can be ‘rolled over’ at a newly set rate of
interest to reflect changes in the expected rate of
inflation.
• On the other hand, lenders can set a floating interest
rate, which is adjusted to the inflation rate changes.
 Cont’d
• Real interest rate is the difference between the
nominal rate of interest and the expected rate of
inflation. It is a measure of the anticipated
opportunity cost of borrowing in terms of goods and
services forgone.
 Cont’d
• The dependence between the real and nominal
interest rates is expressed using the following
equation:

i = (1+ r)(1+ ie) - 1

 where i is the nominal rate of interest,
 r is the real rate of interest and
 ie is the expected rate of inflation.
 Cont,d
 Assume that a bank is willing to make a loan to you of
Br1,000 for one year at a real rate of interest of 3 per cent.

 This means that at the end of the year the bank expects to
receive back Br1,030 of purchasing power at current prices.
 However, if the bank expects a 10 per cent rate of inflation
over the next twelve months, it will want Br1,133 back (10
per cent above Br1,030). The interest rate required to
produce this sum would be 13.3 per cent.
 solution
i = (1+ r)(1+ ie) - 1
The theory and structure of interest rates
There are two economic theories explaining the level
of real interest rates in an economy:
 The loanable funds theory

 Liquidity preference theory

 Loanable funds theory
In an economy, there is a supply of loanable fund (i.e.,
credit) in the capital market by households, business,
and governments.
Loanable funds are funds borrowed and lent in an
economy during a specified period of time – the flow of
money from surplus to deficit units in the economy.
The higher the level of interest rates, the more such
entities are willing to supply loan funds; the lower the
level of interest, the less they are willing to supply.
 Cont,d
• These same entities demand loanable funds, demanding
more when the level of interest rates is low and less
when interest rates are higher.
According to the scholars , the level of interest rates is
determined by the supply and demand of loanable funds
available in an economy’s credit market (i.e., the sector
of the capital markets for long-term debt instruments).
• This theory suggests that investment and savings in the
economy determine the level of long-term interest rates.
 Cont,d
• Short-term interest rates, however, are determined
by an economy’s financial and monetary conditions.

 According to loanable funds theory for the

economy as a whole:
 
 Demand for loanable funds = net investment + net
additions to liquid reserves
 
 Supply of loanable funds = net savings + increase in
the money supply
 liquidity preference theory

Saving and investment of market participants under

economic uncertainty may be much more influenced
by expectations and by exogenous shocks than by
underlying real forces.
• A possible response of risk-averse savers is to vary
the form in which they hold their financial wealth
depending on their expectations about asset prices.
 Cont,d
 
• Liquidity preference theory: which explains how
interest rates are determined based on the preferences of
households to hold money balances rather than
spending or investing those funds.
– Liquidity preference is preference for holding financial
wealth in the form of short-term, highly liquid assets rather
than long-term illiquid assets, based principally on the fear
that long-term assets will lose capital value over time.
 Cont,d
• Money balances can be held in the form of currency or
checking accounts, however it does earn a very low
interest rate or no interest at all. A key element in the
theory is the motivation for individuals to hold money
balance despite the loss of interest income.
• According to the liquidity preference theory, the level
of interest rates is determined by the supply and demand
for money balances. The money supply is controlled by
the policy tools available to the country’s Central Bank.
 Loanable funds and liquidity preference

• It is commonly argued that the two theories are, in fact, are

complementary, simply looking at two different markets
which are:
1. The market for money and

2. The market for non-money financial assets,

• Both the above two markets of which have to be in

equilibrium if the system as a whole is in equilibrium.
 Structure of interest rates
• Interest rate structure is the relationships between the
various rates of interest in an economy on financial
instruments of different lengths (terms) or of different degrees
of risk.

 The variety of interest rates that exist in the economy and

the structure of interest rates are subject to considerable
change due to different factors. Such changes are important
to the operation of monetary policy.
 cont’d
• Interest rates vary because of differences in the time
period, the degree of risk, and the transaction costs
associated with different financial instruments

• The greater the risk of default associated with an asset,

the higher must be the interest rate paid upon it as
compensation for the risk. This explains why some
borrowers pay higher rates of interest than others.
 cont’d
• The degree of risk associated with a request for a
loan may be determined based up on a
• company’s size,
• profitability or past performance;
• or, it may be determined more formally by credit rating
agencies.
• Borrowers with high credit ratings will be able to have
commercial bills accepted by banks, find willing takers for
their commercial paper or borrow directly from banks at
lower rates of interest.
 Theories of Term Structure of
Interest Rates
• There are several major economic theories
that explain the observed shapes of the yield
curve:
Expectations theory
Liquidity premium theory
Market segmentation theory
Preferred habitat theory
 Expectations theory

• The pure expectations theory assumes that

investors are indifferent between investing for
a long period on the one hand and investing
for a shorter period with a view to reinvesting
the principal plus interest on the other hand.
 Cont,d
• For example an investor would have no preference
between making a 12-month deposit and making a
6-month deposit with a view to reinvesting the
proceeds for a further six months as long as the
expected interest receipts are the same.

• This is equivalent to saying that the pure

expectations theory assumes that investors treat
alternative maturities as perfect substitutes for one
another.
 Cont,d
• The pure expectations theory assumes that
investors are risk-neutral.
• A risk-neutral investor is not concerned about the
possibility that interest rate expectations will prove
to be incorrect, as long as potential favourable
deviations from expectations are as likely as
unfavourable ones. Risk is not regarded negatively.
 Liquidity Premium Theory

• Some investors may prefer to own shorter

rather than longe term securities because a
shorter maturity represents greater liquidity.

• In such case they will be willing to hold long

term securities only if compensated with a
premium for the lower degree of liquidity.
 Cont,d
• Though long-term securities may be liquidated
prior to maturity, their prices are more
sensitive to interest rate movements.

• Short-term securities are usually considered

to be more liquid because they are more likely
to be converted to cash without a loss in
value.
• Thus there is a liquidity premium for less
liquid securities which changes over time.
 Market Segmentation Theory
• According to the market segmentation theory,
interest rates for different maturities are
determined independently of one another.
The interest rate for short maturities is
determined by the supply and demand for
short-term funds.
• Long-term interest rates are those that equate
the sums that investors wish to lend long term
with the amounts that borrowers are seeking
on a long-term basis.
 Cont,d
• According to market segmentation theory,
investors and borrowers do not consider their
short-term investments or borrowings as
substitutes for long-term ones.
• This lack of substitutability keeps interest
rates of differing maturities independent of
one another.
• If investors or borrowers considered
alternative maturities as substitutes, they may
switch between maturities.
 Cont,d

• However, if investors and borrowers switch

between maturities in response to interest
rate changes, interest rates for different
maturities would no longer be independent of
each other. An interest rate change for one
maturity would affect demand and supply,
and hence interest rates, for other maturities.
 The Preferred Habitat Theory

• Preferred habitat theory is a variation on the

market segmentation theory. The preferred
habitat theory allows for some substitutability
between maturities. However the preferred
habitat theory views that interest premiums
are needed to attract investors from their
preferred maturities to other maturities.
 Cont,d
• According to the market segmentation and preferred
habitat explanations, government can have a direct
impact on the yield curve. Governments borrow by
selling bills and bonds of various maturities.

• If government borrows by selling long-term bonds, it

will push up long-term interest rates (by pushing down
long-term bond prices) and cause the yield curve to be
more upward sloping (or less downward sloping)
• If the borrowing were at the short maturity end,
short-term interest rates would be pushed up.