UNIT 2: INTEREST RATES AND
SECURITY VALUATION
(4)
Chapter Outline
2.1. Interest rates
2.1.1. Determination of interest rate
2. 2.1.2.Term structure of interest rates and theories of termstructures
2.1.3. Real and nominal interest rates.
Interest Rates: Level of Interest Rate, Determinants of
Market Interest Rates, Interest Rates and Business
Decisions.
Interest Rates:
An interest rate is the percentage of principal charged by the lender for the use of its money.
The principal is the amount of money loaned.
The interest rate is typically noted on an annual basis known as the annual
percentage rate (APR).
Interest provides a certain compensation for bearing risk.
The assets borrowed could include cash, consumer goods, or large assets such as a vehicle or
building.
Interest is the cost of borrowing money, and an interest rate tells you how quickly those
borrowing costs will accumulate over time.
For example, if someone gives you Rs. 10,000 a one-year loan with a 10% interest rate, you'd
owe his/her Rs. 11,000 back after 12 months.
Interest rates affect the cost of loans. As a result, they can speed up or slow down the economy.
Interest Rates: Level of Interest Rate, Determinants of
Market Interest Rates, Interest Rates and Business
Decisions.
Types of interest rates:
There are essentially three main types of interest rates:
1. The nominal interest rate.
2. The effective rate.
3. The real interest rate.
The nominal interest rate:
The nominal interest of an investment or loan is simply the stated rate on
which interest payments are calculated.
Essentially, this is the rate on which savings accrue interest over a period
of time.
For example, an investment of Rs. 10,000, at a nominal interest rate of
10% over 1 year, would earn the investor Rs. 1000.
Interest Rates: Level of Interest Rate, Determinants of
Market Interest Rates, Interest Rates and Business
Decisions.
The effective rate.
The effective interest rate (AER) takes into account compounding over the full term of the
investment.
the effective annual interest rate is the rate of interest that an investor can earn (or pay) in a
year after taking into consideration compounding.
It is often used to compare the annual interest rates with different compounding terms (daily,
monthly, annually, etc.).
This means that a nominal interest rate of 10% compounded quarterly would equate to an
effective rate of 10.38%, compounded monthly at 10.47%, and daily at 10.51%.
The EAR formula is given below:
Where:
i = Stated annual interest rate
n = Number of compounding
periods
Interest Rates: Level of Interest Rate, Determinants of
Market Interest Rates, Interest Rates and Business
Decisions.
The real interest rate:
The real interest rate is useful when considering the impact of inflation on nominal interest
rates.
In essence, the real interest rate deducts the rate of inflation from the nominal interest rate.
This means that if the nominal interest rate is 10% and the inflation rate is also 10%, the real
interest rate is effectively 0%.
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
The real interest rate reflects the purchasing power value of the interest paid on an investment
or loan and represents the rate of time-preference of the borrower and lender.
Determinants of Market Interest Rates
Market interest rate is the rate of interest paid on deposit and other
investments determined by the interactions of the supply and demand for
funds in the money market.
This interest rates offered most commonly on deposits in banks, other
interest-bearing accounts, as well as on loans.
The factors affecting the interest rates are called determinants of the
interest rates.
The market interest rate is the function of many factors including the real
cost of money, inflation, risk, etc.
There are different determinants of market interest rates.
Determinants of Market Interest Rates
Market Interest Rate (K)= K* + IP + DRP + LRP + MRP
Where,
K*= Real Risk Free Rate of Interest
IP= Inflation Premium or Interest Premium
DRP= Default Risk Premium
LRP= Liquidity Risk Premium
MRP= Market Risk Premium
Determinants of Market Interest Rates
Real Risk Free Rate of interest (K*):
Real Risk-Free Rate is defined as the interest rare that would exist on
riskless security if no inflation were expected or when inflation is zero.
It is the rate of interest from riskless government securuties of inflation but
this rate of interest is never seen in the economy because inflation is never
expected.
Nominal Risk-free Rate:
The nominal rate is defined as the actual rate of interest charged by the
supplier of funds ans paid by the demander of funds and it is always
composed of the real risk-free rate of interest and premium of inflation
Risk Free Rate (RF) = K* + IP
Determinants of Market Interest Rates
Inflation Premium or Interest Premium (IP):
Gradually increase in the price of commodity is called inflation.
Ghange in the purchasing power of the monry or change in the value of money.
Inflation premium is the component of a required return that represents
compensation for inflation risk.
The portion of an investment's return that compensates for expected increases
in the general price level of goods and services.
Year Inflation Rate
Inflation Premium (Ipn ) = (I1+ I2 + I3 + ………..+ In ) /n (%)
1 4
Ex.
2 6
IP1 = I1 /1 3 5
IP= IP3 = (4+6+5)/ 3
IP2 = (I1+ I2) /2 =5%
Determinants of Market Interest Rates
Default Risk Premium (DRP):
The DRP is the risk that a borrower will default on a loan which means not
pay the interest or the principal. Higher the default risk higher will be the
interest rate and vice-versa.
K = K* + IP + DRP
Where, IP = Inflation Premium.
Note: IN government securities, DRP =0.
Liquidity Risk Premium (LRP):
The premium for lower marketability of securities.
LRP is the premium charged for taking the risk on security with a weak
liquidity.
K = K*+ IP+DRP+LRP
Determinants of Market Interest Rates
Maturity Risk Premium (MRP):
The premium for longer maturity of the securities.
MRP is the premium charged by the investor for capital losses due to the
change in the market interest rate.
0Kn= K* + IP + DRP + LRP + MRP
Eg.
0Kn = 3 + 4 + 0.45 +1 + 2
K = 10.45 %
0Kn = The market rate of interest on a ‘n’ year security, which differ from
one security to another depending upon the nature of risk associated.
The Term Structure of Interest Rates
The term structure of interest rate shows the relationship between interest
rates and time to maturity.
It shows the relationship between yields and maturities.
Generally short-term interest rates are lower than the long-term rates.
The investors and borrowers should understand that how long-term and
short-term rates are related and what factors causes to shift in their relative
positions.
The investors and borrowers can use the term structure of interest rate to
decide whether to invest or borrow in long-term or short-term bonds/ debt.
The graphical presentation of term structure of interest rate is called yield
curve.
The Term Structure of Interest Rates
The Term Structure of Interest Rates
Yield curve filutuate depending on
the general supply and demand
condition of funds.
The Shape of yield curve change on
the future rate of inflation expected
by investors.
The yieldcurves for corporate
securities lie above the yield curve
for Treasury securities depending
on the extent of default risk and
liquidity risk perceived for
corporate securities.
The Term Structure of Interest Rates
Yield curve: It is a graphical relationship between the yield to maturity and
terms to maturity of financial securities.
Term Structure Theories
Any study of the term structure is incomplete without its background theories. They
are pertinent in understanding why and how are the yield curves so shaped.
a. Pure Expectations Theory : A theory which asserts that the shape of yield
curve depends on investors’ expectations about future inflation rates.
(1+0kn) = [(1+0k1)(1+0k2)(1+0k3)……….(1+n-1Kn)]1/n Or
Where
0kn = Current yield on n- year securities.
0k1 = Current yield on 1- year securities.
1k2 = Yield on 1- year securities next year.
2k3 = Yield on 1- year securities two years from now.
n-1 Kn = Yield on 1- year securities n-1 years from now.
Term Structure Theories
b. Liquidity Preference Theory : A theory which asserts that investors require a
premium to hold long-term securities due to poor liquidity. So. long-term Interest
rates are generally higher than the short-term rates due to the lower liquidity.
(1+0kn ) = [(1+0k1)(1+0k2)(1+0k3)……….(1+n-1Kn)+LPn]1/n
Or
(1+0kn )n - LPn = (1+0k1)(1+0k2)(1+0k3)……….(1+n-1Kn)
c. Market Segmentation Theory : The market for debt is segmented on the basis
of the maturity preferences of different types of financial institutions and
individuals.
When supply exceeds demand for short-term loans, short-term rates are lower
than long-term interest rate.
If demand for long-term loan is higher than the supply of funds, the long-term
rates will increase.
Level of Interest Rate
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for
money or credit will raise interest rates, while a decrease in the demand for credit will decrease
them.
Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the
supply of credit will increase them.
An increase in the amount of money made available to borrowers increases the supply of credit.
The more banks can lend, the more credit is available to the economy. And as the supply of credit
increases, the price of borrowing (interest) decreases.
Credit available to the economy decreases as lenders decide to defer the repayment of their loans.
For instance, when you choose to postpone paying this month's interest payable until next month
or even later, you are not only increasing the amount of interest you will have to pay but also
decreasing the amount of credit available in the market. This, in turn, will increase the interest
rates in the economy.
Level of Interest Rate
Quantity of Financial Capital Demanded Quantity of Financial Capital Supplied
Interest Rate (%)
(Borrowing) (Lending)
11 Rs.800 Rs. 420
13 Rs.700 Rs.510
15 Rs.600 Rs.600
17 Rs.550 Rs.660
19 Rs.500 Rs.720
21 Rs.480 Rs.750
Level of Interest Rate
Interest Rates and Business Decisions
When interest rates rise, banks charge more for business loans. This means you'll need to use
more of your earnings to pay interest on your loans, which decreases profits. You might decide
not to start new projects or expansions during periods of high interest rates, which hampers the
growth of the company.
When interest remains low, businesses can borrow more readily. Low-interest loans can fund
business growth and increase profitability because businesses can earn enough off of new
ventures to pay for the loan interest and have money left over for profits.
Businesses can invest their excess cash in interest-bearing accounts to make more money.
During periods of high interest rates, businesses earn more from these investments.
When rates are low, businesses may be more likely to use their cash for new equipment and
plant improvements. While this can be good for equipment sellers and construction firms,
banks lose out.
Banks make their money from providing loans. When they don't get business investments to
boost their assets, they can't make as much money because they have less to loan out.
Interest Rates and Business Decisions
High interest rates lower consumer income.
High interest rates make it difficult for businesses to obtain loans.
Low interest rates can spur consumer spending.
Low interest rates can spur business expansion and growth.
THANK YOU
Questions and
Queries
