Unit 3
Unit 3
Unit 3
RATES
Structure
3.0 Objectives
3.1 Introduction
3.2 Pure Interest and Gross Interest Rates
3 . 3 Bond Price and Yield to Maturity
3.4 The Term Structure of Interest Rates
3.5 Factors Affecting Market Interest Rates
3.6 Effects of Changes in Interest Rates
3.7 Let Us Sum Up
3.8 Key Words
3.9 Some Useful Books
3.10 Answers/ Hints to Check Your Progress Exercises
3.0 OBJECTIVES
After studying this Unit, you will be able to:
INTRODUCTION
Borrowing and lending in the financial market depend to a
significant extent on the rate of interest. In economics,
interest is a payment for the services of capital. It represents
a return on capital. In other words, interest is the price of
hiring capital. Capital, a s a factor of production, takes the
form of machinery, equipment or any other physical assets
used in production of goods. On the other hand, funds
must be made available to the entrepreneurs for buying
these physical assets. Purchase of capital assets i s called
investment and funds made available for the purchase of
such capital assets is called financial capital. Some persons
have to supply this financial capital to the entrepreneurs
who would use it for investment in real capital assets. The
payment to those who supply financial capital for its use is
called the market rate of interest. This is expressed a s a
percentage of sums of funds borrowed. On the other hand,
the entrepreneur who buys capital equipment and uses it
in the process of production gets addition to his revenue,
which is called return on capital. The return on capital is
the addition to production which increases his revenue.
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Dcterminilr~ts of
3.2 PURE INTEREST AND GROSS Interest Rates
INTEREST RATES
According to Prof. Meyers, interest is the price paid for the
use of loanable funds. Different rates of interest are charged
for the same sum of loan for the same period because of the
fact that some loans involve more risk, more inconvenience
and more incidental work. Thus interest is of two types :
pure interest and gross interest. The pure interest is the
payment for the use of money a s capital when there is
neither inconvenience, risk nor any other management
problem.
I
market return, which results from the alternating bull and
The Basics of Financial bear market forces. The main element that causes the stock
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market to rise 'bullisthly' and then fall 'bearishly' again and
again, is the fact that the nation's economy follows a cycle
of recessions and expansions.
1
Time to Maturity
(B)
Normal Yield Curve Inverted Yield Curve
Yield to
Maturity
Time to Maturity
(C)
Humped Yield Cume
The above-mentioned yield curves are simplified versions of
yield curves. In the practical world however, the shape of
yield curves is much more complex and sometimes it takes
the shape of 'humped curve' [as shown in figure (C)].
There are three theories about how the shape of yield curve
is determined.
1) What
b
do you mean by 'term structure of interest rates?
The Basics of Financial iii) The yield curve slopes upward in the event of falling
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yield rates. (7'1F)
iv) Market Segmentation Theory of interest stipulates
t h a t i n t e r e s t r a t e s for v a r i o u s m a t u r i t i e s a r e
determined by demand and supply conditions in thp
various segments of the market. (TIF)
i) Saving by individuals,
ii) International capital flows, and
iii) Amount of premium required by investors to compensate
for interest rate risk.
1 ) Economic Conditions
2) Monetary Policy
Monetary policy refers to the policy measures adopted by
the Central Bank of the country such a s changes in rate of
interest (i.e, change in cost of credit) and the availability of
credit. The policy regarding the growth of money supply
also comes under the purview of monetary policy. Changes
in bank rate, open market operations, cash reserve ratio of
banks, selective credit controls are the various instruments
of monetary policy.
i) Bank Rate
4) Government Deficit
KEY WORDS
Bear Market : A market in which prices of shares'
and commodities are decreasing.