Slide - Chap 10 Pricing Mech - MOOC

CHAPTER 10
Pricing Mechanism in Banking

Objectives
At the end of this chapter, students will be able to
• 1. Explain what is fixed interest rate and floating interest
rate.
• 2. Explain the concept of OPR, BLR, BR, Spread and
KLIBOR
• 3. Describe the components of BR.
• 4. Calculate BR and the interest rate on loan.
• 5. Describe the four methods of calculating interest product
and determining monthly repayments (the Cost-Plus
Pricing Model).
• 6. Explain the impact of the above three methods of
calculating interest product on monthly instalments.
• 7. Explain the rationale of charging penalty interest.
Simple Interest
Principal x Rate x Time/Tenor

100 x 365
Simple Interest
Assume a RM1 million loan is given for 1 year
and is charged interest at 6% p.a.
RM1,000,000 x 6 x 365 days = RM60,000

100 x 365 days
Total Loan:
= RM1,000,000 + RM60,000
= RM1,060,000.
Exercise 1
• A loan of RM10,000 is given
for 1 year at 2% per month.
Calculate:
• 1. Interest amount
• 2. Principal + interest
Coupon interest
Interest is paid at the end of investing period.

Compound interest
Y Amount Rate Annual Balance at
of S/D Interest Year End
1 RM10,000 3% p.a. RM300.00 RM10,300
2 RM10,300 3% p.a. RM309.00 RM10,609
3 RM10,609 3% p.a. RM318.27 RM10,927.27
Interest is calculated based on future value concept,

which is Future Value = Present Value (1+ R)n
Interest at end of period 1 is capitalized (added to principal) to become a

new, bigger principal at the beginning of period 2 and so on.
Exercise 2
• RM5,000 is invested for 7 years at interest rate
of 3% compounded for first 3 years, and 4%
compounded for the second 4 years.
• Future value of investment at end of year 4?
Exercise 2 (Answer)
• RM5,000 is invested for 7 years at interest rate
of 3% compounded for first 3 years, and 4%
compounded for the second 4 years.
• Future value of investment at end of year 7?
= RM5,000(1+3%)3 + {(RM5,000(1+3%)3(1+4%)4 }
Discount interest
Interest is paid at the beginning of investing period (by deducting from the
principal).
Interest is calculated based on present value concept, which is

Present Value = Future Value
(1+ R)n
Exercise 3
• You borrow RM50,000 under Banker’s Acceptance for
6 months at discount rate of 8% p.a.
• How much will you receive?

Exercise 3 (Answer)
• You borrow RM50,000 under Banker’s Acceptance for
6 months at discount rate of 8% p.a.
• How much will you receive?
= RM50,000___
(1 + 8%)180/365
Effective interest rate
Discount interest calculation generates a higher effective rate, since the principal
amount invested at the beginning of investing period is smaller than that under
compound interest calculation.
Yield
Yield Curve Positive

Negative
Flat
Yield Curve
Banker’s Strategies
Positive Yield Curve
• Borrow Long, Lend Short
Negative Yield Curve

• Borrow Short, Lend Long
Flat Yield Curve

• either one of the above, depending on the
transitional direction of the yield curve
Fixed vs. Floating Interest Rate
• Fixed – a loan at 9% p.a. for 5 years.
• Floating – BR + 2% p.a.
Overnight Policy Rate (OPR)
• Interest rate set by Bank Negara M’sia. The rate is used
by banks for charging interest on overnight loans.
• Changes in OPR will change KLIBOR, Based Rate and
bank’s lending rates in the same direction:
Banks’
Based
OPR KLIBOR Lending
Rate
Rates
This precess
KLIBOR
• It’s Kuala Lumpur Inter-bank Offered Rate – which is the
average interest rate offered on terms deposits.
• Rates are contributed by 12 banks designated by Bank
Negara Malaysia.
• At 11 am on each business day, each bank will submit
their rates per transaction size of RM5 million and for
tenors of 1, 3, 6, 9 and 12 months.
KLIBOR ………….
• Example: Assumed KLIBOR is taken on 6 banks on one business day
KLIBOR Submitter Interest Rate on

3-month NID, p.a. Remark
Maybank 2.7% Lowest
CIMB Bank 3.3%
Public Bank 3.7%
RHB Bank 3.4%
Hong Leong 3.9% Highest
AmBank 3.6%
= KLIBOR = (3.3% + 3.7% + 3.4% + 3.6%) = 3.5% p.a.
• 4
Note that the two extremes (highest and lowest) are excluded in determining the
average rate.
Base Rate (BR)
Sample Pricing on loan to Borrower A
Quanti Borrower
-fied A
Rating
Credit Risk 0 – 1% 0.25%
Profit Margin 0 – 2% 1.25%
Liquidity Risk 0 – 1% 0.30%
Operating Cost 2.2%
BR 5.0 5.0%
Interest rate on this loan 9.0%
Banks with lower operating costs and risks can afford to offer more competitive
rates. Thus, banks use technology and cut down on people and physical
branches to reduce operating costs.
Base Rate (BR)…..
• The formula for calculating BR is
1 x 3-Month KLIBOR
(1−SRR)
Based on the following information, calculate BR:

SRR = 3.8%, KLIBOR 3-month=3.67
Date Overnight 1-week 1-month 3-month
1/6/2015 3.24 3.26 3.28 -
2/6/2015 3.24 3.26 3.28 -
3/6/2015 3.24 3.25 3.28 3.67
4/6/2015 3.23 3.25 3.29 -
5/6/2015 3.16 3.25 3.28 3.67
6/6/2015 3.16 3.25 3.28 3.67
7/6/2015 3.16 3.25 3.28 3.
Source: BNM, May 2016
Traditional Pricing Methodology
Flat Annual
Rate Rest
Monthly Daily
Rest Rest
Flat Rate Basis
• Example: Personal Loan of RM1,000,000 for 10 years at 10% p.a.
flat.
• Total Interest Charged = RM1,000,000 x 0.1 x 10
• = RM1,000,000
•
• Total amount owed (total Debt) = Principal + Interest
• = RM1,000,000 + RM1,000,000.
• = RM2,000,000.
•
• The Monthly Instalment on the loan will be:
• _______RM2,000,000______
(10 years x 12 months)
•
• = RM16,666.67.
• Yearly Instalment = RM16,667.67 x 12 = RM200,000
Flat Rate Basis………
Interest is calculated based on the same amount of principal over the borrowing period.
This calculation ignores the gradual reduction in principal over times. As a result, amount
of monthly instalment is highest compared to the other 3 methods.
Annual-Rest Basis
Interest rate calculation that is based on an Annual-Rest Basis is more

advantageous to the borrower - amount of interest and monthly instalment are
much smaller than those under the Flat-Rate interest calculation.
Monthly-Rest Basis
Interest is calculated monthly based on the monthly

reduction in amount of principal. This calculation
produces the amount of monthly instalment that is
lower than that under Annual Rest.
1 2 3 4 Year
Daily Rest Basis
• Interest is calculated daily based on the daily

reduction in amount of principal. This calculation
produces the amount of monthly instalment that is
lowest among the 4 methods discussed above.
Monthly-Rest Basis vs Others
Loan of $100k for 4 years at 2% p.a.
Flat P1 – 4 =$100k ; M. Instalment=$ RM2,000

Yearly
P1=$94k; M Inst.= $1,990
Rest
P1=$93K; M. Inst.=$1,895 YR: Ẍ M. Instalment = $1,800
Monthly
Rest
P3=$70k; M Inst.= RM1,600
P3=$50K; M. Inst.=$1,100
Daily
Rest
MR: Ẍ MI.= $1,400
DR Ẍ MI= RM1,100
1 2 3 4 Year
The above calculation is only meant to show differences among the 4 methods.
Retirement of Principal and Interest
Retirement of Principal and Interest
Advantages:
Bank reports bigger profits in early years
Banks can reinvest the interest incomes

to earn additional income
Effective returns on the loans are higher
Should the loans turn bad, which is more

likely in the latter periods, banks have
earned interest incomes on the loans.
Penalty Interest
It serves to
encourage
borrowers to pay
on time and
regularly
Advanced Pricing Methodology
a.Risk-Adjusted Return on Loan
b.Price Leadership Model
c.Below-Prime Market Pricing
d.Customer Profitability Analysis
e.Price Bundling
f. Relationship Pricing
Summary
By now you should be able to:
1. Explain what is fixed interest rate and floating interest rate.
2. Explain the concept of OPR, BLR, BR, Spread and KLIBOR
3. Describe the components of BR.
4. Calculate BR and the interest rate on loan.
5. Describe the four methods of calculating interest product and
determining monthly repayments (the Cost-Plus Pricing
Model).
6. Explain the impact of the above three methods of calculating
interest product on monthly instalments.
7. Explain the rationale of charging penalty interest.
Quiz
1.You can expect the amount of
your monthly instalments to
change when your loan is under
a floating-rate basis.
a. True
b. False
Quiz
2.For a fixed-rate loan, the
applicable interest rate remains
the same throughout the
borrowing period.
a. True
b. False
Quiz
3.Base Rate (BR) consists of
Benchmark COF and Statutory
Reserve Ratio.
a. True
b. False
Quiz
4.KLIBOR is an average rate for
term deposit of the designated
banks in Malaysia
a. True
b. False
Quiz
5.Based on the component of
interest-spread on a loan, you can
tell how much profit the bank is
making on that loan.
a. True
b. False
Quiz
6.The amount of monthly
instalment is bigger for loan whose
interest is calculated based on
annual-rest basis than when it is
under flat-rate basis.
a. True
b. False
Quiz
7.Generally, borrowers prefer
daily-rest basis better than
monthly-rest basis.
a. True
b. False
Quiz
8.Loans calculated on daily-rest
basis is worst for borrowers who
have the habit of defaulting on
payment of monthly instalments.
a. True
b. False
Answer to Quiz
True for Q1,2,3,4,5,7,8 and false for Q6.

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CHAPTER 10

Pricing Mechanism in Banking

Principal x Rate x Time/Tenor

RM1,000,000 x 6 x 365 days = RM60,000

Interest is paid at the end of investing period.

2 RM10,300 3% p.a. RM309.00 RM10,609

3 RM10,609 3% p.a. RM318.27 RM10,927.27

Interest is calculated based on future value concept,

Interest at end of period 1 is capitalized (added to principal) to become a

Interest is calculated based on present value concept, which is

• How much will you receive?

• How much will you receive?

Yield Curve Positive

Negative Yield Curve

Flat Yield Curve

KLIBOR Submitter Interest Rate on

Profit Margin 0 – 2% 1.25%

Liquidity Risk 0 – 1% 0.30%

Operating Cost 2.2%

Interest rate on this loan 9.0%

Based on the following information, calculate BR:

Interest rate calculation that is based on an Annual-Rest Basis is more

Interest is calculated monthly based on the monthly

• Interest is calculated daily based on the daily

Flat P1 – 4 =$100k ; M. Instalment=$ RM2,000

Bank reports bigger profits in early years

Banks can reinvest the interest incomes

Effective returns on the loans are higher

Should the loans turn bad, which is more

True for Q1,2,3,4,5,7,8 and false for Q6.

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