INTEREST RATES AND

THEIR ROLE IN FINANCE

INTEREST RATE – denotes
percentage earnings or yield on
investment. It is the cost of using
money expressed as a percentage
of the principal for a given period
of time, which is usually per year. It
is generally regarded as the cost of
borrowing or lending out money or
the cost of credit.
• INTEREST RATE fluctuates and
affects market prices of securities
in the financial markets and the
prices of goods and services. The
higher the interest rate, the
better it would be for investors,
but it is undesirable for
borrowers for they have to pay a
higher cost of their borrowings.
DEMAND FOR AND VELOCITY OF MONEY
Nominal interest rate, the monetary
return on saving, is determined by the
supply and demand of money in an
economy. The amount of money that
people desire to hold as a store of
value is the demand for money. It is
how much money people and firms
decide to hold in their wallets or
coffers.
The primary benefit of holding money is
that it is the most liquid of all assets. So,
the demand for money is the demand for
liquidity. As it turns out, the price of
money is the opportunity cost of holding
money. Since cash does not earn
interest, people give up the interest that
they have earned on non cash savings
when they choose to keep their wealth in
cash.
REASONS FOR HOLDING THE MONEY
1. TRANSACTION DEMAND – Since
payment for expected expenditures like
purchases of goods, payment for
electricity bill, water bill, telephone bill,
tuition fee and others, does not coincide
with the receipt of income, people tend
to hold on to money to pay for all those
expenses
2. PRECAUTIONARY DEMAND – Others
hold on to money in preparation for
unforeseen additional expenses caused
by unexpected events like sickness,
injury from accident, or loss of property.
3. SPECULATIVE DEMAND- For some,
particularly businessmen and investors,
they hold on to money with the
intention of using it when an
opportunity to earn more arises.
VELOCITY OF MONEY – is the average
number of times a unit of currency is used
to purchase final goods and services.

V=(P*Y)/M
Where P – the price level
Y – real output
M –the money supply
P*Y – nominal output
VELOCITY OF MONEY can be defined
as the number of times that a unit of
money is spent on the total value of
goods and services produced per year.
It refers to the number of times per
year that a peso or currency travels
around the economy from wallet to
wallet, person to person, firm to firm,
person to firm, and firm to person.
The demand for money has an
inverse relationship with the
velocity of money. A low demand
for money means that people hold
only a small amount of money
many times. On the other hand, if
there is a high demand for money,
people hold more money in their
wallets.
 INTEREST RATE, PRICES, DEMAND FOR
MONEY AND VELOCITY OF MONEY
Basically, interest rates and prices are
among the factors that causes the
demand for money to rise or fall. As the
real rate of interest rises, the opportunity
cost of holding money rises. As the cost of
holding money rises, people will desire to
hold less money. Therefore IR rises,
demand for money falls.
When the interest rate increases,
the demand for money decreases,
resulting in an increase in the
velocity of money. When the
interest rate decreases, the
demand for money increases,
resulting in a decrease in the
velocity of money.
Prices also affect the demand for
money. Consumers need money to
purchase goods and services. The most
important variable in determining
money demand is the average price
level within the economy. If the
average price level is high and g/s tend
to cost a significant amount of money,
consumers will demand more money.
As price increase, the demand for
money increases. Higher prices
increase the quantity of money
demanded because people are
looking after the fact that they
need more money to buy g/s.
Therefore, there is a direct
relationship between prices of g/s
and the demand for money.
When interest rate falls, the
demand for money increases, the
velocity of money goes down, and
prices go up and vice versa.
Therefore, interest rate and prices
have an inverse relationship with
one another. When IR goes down,
prices go up; when IR goes up,
prices go down.
TYPES OF INTEREST
NOMINAL INTEREST RATE- is the
simplest type of interest rate. It is the
stated IR of a given bond or loan. This
type of IR is referred to as the coupon
rate for bonds and other fixed-income
investments or loans granted by
financial institutions.
 REAL INTEREST RATE – it states the
real rate that the lender or investor
receives or a borrower pays after
considering inflation. It is also the
IR that is adjusted for expected
changes in the price level to
accurately reflect the trues cost of
borrowings.
NR= Real IR + Expected Rate of Inflation
RIR = NR – Expected Rate of Inflation
Assuming the NIR is 8% and the
expected rise in the price level is 3%,
then the RIR is 8% - 3% = 5%. If the
expected inflation rate is higher than
the NR, it is better to spend the money
now because it will just lose its value.
FIXED INTEREST RATE - means
that the interest rate that you will
charged over the term of your loan
will not change, no matter how
high or how low the market may
drive interest rates. Your payment
will remain the same on your last
payment as it was on your first
payment.
VARIABLE INTEREST RATE – also
called floating rate. It means that
the interest you are charged
changes as whatever index your
loan is based on changes. Loans
can be based on the rate of 1-year
T-bill or the prime lending rate
among other factors.
INTEREST RATE AND THE ECONOMY
1. Ensure that current savings will flow into
investment to promote economic
growth.
2. Ration the available supply of credit to
provide loanable funds to those
investment projects with the highest
expected returns.
3. Bring into balance the supply of money
with the public`s demand for money.
4. Act as an important government
tool through its influence on the
volume of savings and investment. If
the economy is growing too slowly and
unemployment is rising, the
government can use its policy tools to
lower interest rates in order to
stimulate borrowing and investment
which will eventually encourage
production and create employment.
INTEREST RATE THEORIES
1. CLASSICAL THEORY – this is one of
the oldest theories concerning the
determination of the pure or risk-free
interest rates. It is referred to as the
Fisher hypothesis. It also states that IR
in the financial markets were
determined by the interplay of the
supply of savings and the demand for
investment.
2. LOANABLE FUNDS THEORY -
posits that borrower create the
demand for loanable funds and
the lenders, on the other side of
the market, seek to provide the
loanable funds needed by the
borrowers.
3. LIQUIDITY PREFERENCES
THEORY – stipulates that the
interest rate is determined in
the money market by the
money demand and the money
supply.
4. RATIONAL EXPECTATIONS THEORY
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 RATES
[Link] expectations
[Link] policy
[Link] cycle
[Link] budget deficits
MEASUREMENT OF INTEREST RATES
1. SIMPLE INTEREST RATE
From the point of view of saver, the IR is
the percentage of interest income received
over the money lent for a period of time,
and from the point of view of the user, the
interest rate is the percentage of interest
expense paid over the money borrowed for
a period of time.
EXAMPLE: SAVER
Mr. A placed his P1,000,000 in a special deposit
account with Bank X for 1 year. At the end of the
year, he received P1,100,000. The interest rate
from the transaction is 10% computed as
follows:
IR=Interest Income/Principal
IR=(P1,100,000-P1,000,000)/P1,000,000
IR=P100,000/P1,000,000
IR=10%
EXAMPLES: USER
Mr. B needed P1,000,000 for additional funding
of his business. Bank X lent him the required
fund for 1 year. At the end of the year, Mr B paid
Bank X the amount of P1,200,000. The interest
rate from the transaction is 20% computed as
follows:
IR=Interest Expense/Principal
IR=(P1,200,000-P1,000,000)/P1,000,000
IR=P200,000/P1,000,000
IR=20%
2. COMPOUND INTEREST RATE
Compounding involves giving
interest to interest earned, that is,
the interest earned in the 1 st

period is added to the principal.

The result becomes the principal
for the 2nd period, thereby earning
a higher interest in the 2nd period.
EXAMPLE:
If a bond pays 6% on an annual basis and
compounds semi-annually, then an
investor who invests P1,000 in this bond
will receive P30 of the interest after the 1st
6 months, and P30.90 of interest after the
next 6 months.
Note: The difference between the NR and
ER increases with the number of
compounding periods within a specific
time period.
3. EFFECTIVE INTEREST RATE (EIR)
A. TRADE CREDIT – it is a spontaneous
credit from regular purchase of goods.
Some suppliers provide credit terms and
cash discounts for early payment such as
2/10, n/30. The DR is 2% which means that
2% of the invoice price is deducted once
paid within the discount period. The
effective cost of foregoing the discount is
computed as follows:
EIR = [Dr/(1-Dr)] x [1/(T/360)]
Where
Dr =Discount Rate
T=No. of days from the discount period to
the date of payment

EIR = [.02/(1-.02)] x [1/(20/360)]

= .0204 x 1/.0556
= .0204 x .18
= .3672 or 36.72%
B. Bank loans in the form of line of credit
are lending arrangement between a bank
and a borrower, in which the bank provides
the borrower a maximum amount of funds
during a specified period of time. Normally
the bank requires the borrower to
maintain a minimum cash balance in the
bank called compensating balance
throughout the term of the loan. It could
also be a discounted loan in which interest
in paid in advance.
Example:
ABC Corporation has a line of credit with
Bank X for P10,000,000 for the 2016. For any
amount borrowed, the bank requires the
borrower a maintaining balance of 5%.
Assuming the company needed P2,000,000
cash on June 30, 2016 and availed of the
credit line of 12% interest payable on
December 31, 2016. assuming further that
the company has no existing deposit with the
bank, what is the EIR from this transaction?
Amount Borrowed=Funds needed/(1-Rate of CB)
= P2,000,000/(1-.05)
= P2,000,000/.95
=P2,105,263

CB= P2,105,263 x 5%
= P105,263

Net Proceeds = Amount Borrowed-CB

= P2,105,263-P105,263
= P2,000,000
 Interest 1
EIR = -------------------- x ---------
Cash Proceeds T
(P2,105,263x12%x6/12) 1
EIR = --------------------------------------- x ---------
(2,105,263-(2,105,263x5%) 6/12
126,316 1
EIR = -------------------- x ---------
2,000,000 .5
EIR = .063158 x 2
EIR = .1263 or 12.63%
Assuming from the example that the interest is
deducted in advance, what is the EIR?
126,316
EIR = --------------------------------------- x 2
2,105,263-105,263-126,316
126,316
EIR = ----------------------- x 2
1,873,684
EIR = .0674158 x 2
EIR = .1348 or 13.48%
c. Bank loan in the form of transaction
loan. This is unsecured short term
bank credit for a specific purpose. It
could be a discounted loan with
compensating balance requirements
or regular loan in which the interest is
paid at the maturity period. The
formula in determining the EIR is the
same as in (b).
4. Yield to Maturity – is the interest
rate which equates the PV of all
cash flow from debt instrument
with the current value; hence the
net PV is equal to zero. It is also
known as the IRR. There are
different ways to measure yield to
maturity depending on the type of
instrument.
a. For simple loan, YM=simple interest rate
Example: a 1-year bond purchased at
P10,000 is payable at P11,000.
11,000 - 10,000
YM=------------------------------
10,000
YM=10%
b. For coupon bond in which interest is
paid annually and the principal is paid
at the maturity period, the estimated
yield to maturity (EYM) and
interpolation can be used in
determining the actual YM.
I + [(FV-PP)/n]
EYM=-------------------------------
(FV+PP)/2
Where:
I = interest based on nominal rate
FV = Face value of the bond
PP = Purchase price of the bond
N = Number of years before maturity
Example:
A 10%, 5 year bond of P10,000 was
purchased for P9,800. What is the YM?
 1,000 + [(10,000-9,800)/5]
EYM =---------------------------------------------
(10,000+9,800)/2
= 1,040/9,900
= 10.50%
The yield to maturity is between 10%-11%. To
compute for the exact YM, interpolation is
applied.
 at 10% at 11%
PV of Interest 3,791 3,696
PV of FV 6,209 5,930
Total 10,000 9,626

PV of Int 1,000 [1-(1 +.10)-5]/.10

PV of FV 10,000/(1+.10)5
Interpolation
At 10% PV=10,000 At 11% PV=10,000
9,800 9,626
Difference 200 374

200/374 = .535% +10%

10.535%
c. Current Yield (CY) is the yearly coupon
payment (C) divided by the price of the
security (P).
CY = C / P
Bonds with a purchase price of P10,000 and a
yearly coupon payment of P300 will have a
current yield of 3%. Computed as follows:
CY = 300/10,000
= 3%
d. Yield at discount basis (DY) is computed as:
FV-PP 360
DY = ------------------x----------------------------
FV days to maturity
Where:
FV = Face value of the discount bond
PP = Purchase price of the discount bond
Days to maturity is based on 365 days in a year
Example:
A 1-year bond with face value of P10,000 was
purchased at 9,800. What is the YM?
10,000-9,800 360
DY = ----------------------x----------------------------
10,000 365
DY = 200/10,000 x .986
DY = .0197
DY = 1.97%