Chapter 10
Interest Rate and Its Role in Finance
CONCEPT OF INTEREST RATE
The cost of using money is expressed as a percentage of the principal for a given
period of time, which is usually per year. This plays an important role in finance as it
affects various economic factors like demand for money and the velocity of money.
Types of Demand
Transaction demand – demand for money to pay for the regular expenses of living
like purchase of goods/services, pay bills, etc.
Precautionary demand – demand for money for unforeseen events like sickness,
injury, accidents, etc.
Speculative demand – demand for money with the intention of using money when
the opportunity to earn more arises like the purchase of investment securities or
business opportunities.
THE DIFFERENCE BETWEEN INTEREST RATE AND RATE OF RETURN
Interest rate – the cost of money lent or borrowed. It is the relationship between
the interest and the principal.
Interest Rate = Interest _
Face Value or Principal
Rate of Return – the interest rate plus the change in value (capital gain) in relation
to the principal or face value.
ROR = Interest Rate + MV – FV
FV
INTEREST VERSUS DISCOUNT
Interest – collected at the end of the term.
Interest = Principal x Rate x Time
Discount – interest that is deducted in advance.
Discount = Face Value x Discount Rate x Time
MEASUREMENT OF INTEREST RATE
Simple Interest – the amount paid for money borrowed or lent.
I = Prt F=P+I
Where:
I is interest t is time
P is principal F is future value
R is rate I is interest
Compound Interest – interest resulting from the periodic addition of simple
interest to the principal, which new amount earns interest.
n
F = P (1 + i)
Where:
i is the periodic interest = r/m r is the interest rate per annum
P is principal F is future value
n is m x t t is term of loan m is the number of conversion
periods per year
Yield to Maturity – interest rate that equates the present value of all cash flows
from the debt instrument with the current value.
For a simple loan:
YM = simple interest rate = Prt = Maturity Value – Face Value
Face Value
Real Risk-Free Rate of Interest – the interest rate that would exist on a riskless
security if zero inflation were expected.
Nominal or Quoted Risk-Free Rate of Interest – the interest rate that is
adjusted for inflation.
INTEREST RATE THEORIES
Classical Theory – it posits that the rate of interest is determined by: supply of
savings, and demand for investment capital.
Loanable Funds Theory – Based on the premise that interest rate is the price paid
for the right to borrow or use loanable funds. This theory is often used for
forecasting interest rates.
Liquidity Preference Theory – stipulates that the interest rate is determined in
the money market by the money demand and the money supply.
Rational Expectations Theory – It is based on the premise that the financial
markets are highly efficient institutions in digesting new information affecting
interest rates and security prices.
DETERMINANTS OF INTEREST RATE
1. Inflation Expectations 2. Monetary Policy
3. Business Cycle 4. Government Budget Deficits
5. Savings 6. Investment Demand
7. Money Supply 8. Money Demand
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