UNIT THREE: INTEREST RATES IN THE FINANCIAL SYSTEM

3.1 INTEREST RATES DETERMINATION AND STRUCTURE

3.1.1 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.

Interest rates vary depending on borrowing or lending decision. 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. Such a spread also exists between selling and buying
rates in local and international money and capital markets. 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. In the
short-term international money markets, the spread is lower if there is considerable competition.
Conversely, 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.

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).

There are several factors that determine the risk premium for a non- Government security, as
compared with the Government security of the same maturity. These are (1) the perceived
creditworthiness 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.
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. interest
rate on government short-term or long-term debt, or the base interest rate of the commercial
banks, or a short-term money market rate (EURIBOR). 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.

The rates of interest quoted by financial institutions are nominal rates, and are used to calculate
interest payments to borrowers and lenders. However, the loan repayments remain the same in
money terms and make up a smaller and smaller proportion of the borrower’s income. The real
cost of the interest payments declines over time. Therefore there is a real interest rate, i.e. the rate
of interest adjusted to take into account the rate of inflation. Since the real rate of return to the
lender can be also falling over time, the lender determines interest rates to take into account the
expected rate of inflation over the period of a loan. When there is uncertainty about the real rate
of return to be received by the lender, he will be inclined to lend at fixed interest rates for short-
term.

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.

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.

The dependence between the real and nominal interest rates is expressed using the following
equation:

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

Wherein is the nominal rate of interest, r is the real rate of interest and ie e is the expected
rate of inflation.

Example
Assume that a bank is providing a company with a loan of 1000 thousand. Euro for one year at a
real rate of interest of 3 per cent. At the end of the year it expects to receive back 1,030 thousand.
Euro of purchasing power at current prices. However, if the bank expects a 10 per cent rate of
inflation over the next year, it will want 1133 thousand. Euro back (10 per cent above 1030
thous. Euro). The interest rate required by the bank would be 13.3 per cent

i =(1+ 0.03)(1 + 0.1) - 1 = (1.03)(1.1) - 1 = 1.133 - 1=0.133 or 13.3 per cent

When simplified, the equation becomes: i = r + ie

In the example, this would give 3 per cent plus 10
The real rate of return is thus: r = i - ie

When assumption is made that r is stable over time, the equation provides the Fisher effect. It
suggests that changes in short-term interest rates occur because of changes in theexpected rate of
inflation. If a further assumption is made that expectations about the rateof inflation of market
participants are correct, then the key reason for changes in interestrates is the changes in the
current rate of inflation. Borrowers and lenders think mostly in terms of real interest rates.

3.4 The theory and structure of interest rates

There are two economictheories explaining the level of real interest rates in an economy:

 The loanable funds theory

 Liquidity preference theory

3.5 Loanable funds theory

In an economy, there is a supply loanable fund (i.e., credit) in the capital market by households,
business, and governments. 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.
These same entities demand loanable funds, demanding more when the level of interest rates is
low and less when interest rates are higher.
The extent to which people are willing to postpone consumption depends upon their time
preference.

Time preference describes the extent to which a person iswilling to give up the satisfaction
obtained from presentconsumption in return for increased consumption in thefuture.

Loanable funds arefunds borrowed and lent in an economy during a specified period of time –
the flow of money fromsurplus to deficit units in the economy.
The Loanable Funds Theory wasformulated by the Swedish economist Knut Wicksell in the
1900s. According to him, 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. Short-term interest rates, however, are determined
by an economy’s financial and monetary conditions. According to the 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

Given the importance of loanable funds and that the major suppliers of loanable funds are
commercialbanks, the key role of this financial intermediary in the determination of interest rates
is vivid. The central bank is implementing specific monetary policy; therefore it influences the
supply of loanable funds from commercial banks and thereby changes the level of interest rates.
As central bank increases (decreases) the supply of credit available from commercial banks, it
decreases (increases) the level of interest rates.

3.8 Liquidity Preference Theory of Interest Rates

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. Since they are concerned about the
risk of loss in the value of assets, they are likely to vary the average liquidity of their portfolios.
A liquid asset is the one that can be turned into money quickly, cheaply and for a known
monetary value.

Liquidity preference theory is another one aimed at explaining interest rates. J. M.

Keynes 1936 proposed a simple model, which explains how interest rates are determined based
on the preferences of households to hold money balances rather thanspending or investing those
funds.
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.
Money is the most liquid of all financial assets and, of course, can easily be utilized to consume
or to invest. The quantity of money held by individuals depends on their level of income and,
consequently, for an economy the demand for money is directly related to an economy’s income.
There is a trade-off between holding money balance for purposes of maintaining liquidity and
investing or lending funds in less liquid debt instruments in order to earn a competitive market
interest rate. The difference in the interest rate that can be earned by investing in interest-bearing
debt instruments and money balances represents an opportunity cost for maintaining liquidity.
The lower the opportunity cost, the greater the demand for money balances; the higher the
opportunity cost, the lower the demand for money balance.

Liquidity preference ispreference for holding financialwealth in the form of short-term, highly
liquid assets ratherthan long-term illiquid assets, based principally on the fearthat long-term
assets will lose capital value over time.

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. Conversely, in the loan funds theory the level of interest
rates is determined by supply and demand, however it is in the credit market.

Loanable funds and liquidity preference

Much effort has been put into trying to show the relationship between the two principal theories
of interest rate determination – loanable funds and liquidity preference. It is commonly argued
that the two theories are, in fact, complementary, merely looking at two different markets (the
market for money and the market for non-money financial assets), both of which have to be in
equilibrium if the system as a whole is in equilibrium. Although it is true that, in a technical
sense, the two theories can be assimilated, this is done at the cost of losing the spirit of both
theories.

Let us see why this is so:

Let us assume that there is a sudden, unexplained loss of confidence in financial markets, causing
an increase in the demand for liquidity. The demand for money at each level of interest rates
increases.

Interest rates rise, in the nominal interest rate version of the loanable funds theory, this is
expressed as an increase in the demand for liquid reserves, and the demand for loanable funds
curve shifts up, also causing an increase in nominal interest rates. So far so good, but this sudden
change in confidence would be regarded by loanable funds theorists as irrational behaviour. In
otherwords, it would either not occur or would be seen as temporary and unimportant
inanexplanation of how the economy operated.

The loanable funds view suggested that any instability in interest rates would be caused by the
behavior of governments or central banks. In liquidity preference theory, on the other hand,
instability is inherent in the market economy and there is a possible role for government in
stabilizing the economy.

3.10 The Structure of Interest Rates

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. 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.

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.
Such borrowers are often referred to as prime borrowers. Those less favored may have to borrow
from other sources at higher rates.
The same principle applies to the comparison between interest rates on sound risk-free loans
(such as government bonds) and expected yields on equities. The more risky a company is
thought to be, the lower will be its share price in relation to its expected average dividend
payment – that is, the higher will be its dividend yield and the more expensive it will be for the
company to raise equity capital.