UNIT 3 DETERMINANTS OF INTEREST

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:

Explain the concepts, like pure and gross interest rates,

bond price etc.,
Summarise the important theories of term structure of
interest rates,
Identify the factors influencing market interest rates, and
Describe the effects of changes in interest rates,

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.
- - - - - -
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.

Whereas, gross interest is the gross payment which the

lender gets from the borrower. It includes not only net
interest but also payment for other elements, which have
been outlined below.

Elements of Gross interest

i) Payment for risk : Every loan, if not secured fully, involves

risk of non- payment due to the inability or unwillingness
of the borrower to pay back the debt. The lender charges
something extra for taking such risk.

ii) Payment for inconvenience : The moneylender may add

extra charges for the inconvenience caused to him. The
greater the inconvenience involved, the higher will be such
charge and consequently the gross interest. For instance,
the borrower may repay at a very inconvenient time to the
lender or the borrower may invest the capital for a period
longer than the one for which loan has been given.

iii) Payment for management : The lender expects to be

compensated for the additional work he h a s to do in
connection with lending e.g., the form of keeping accounts,
sending notices and reminders and other incidental work.

jv) Payment for exclusive use of money, i.e. pure interest:

It is the payment for the use of money which is in
addition to payments for the above-mentioned risks,
inconvenience and management.

In short, gross interest is the total payment which the

lender gets from the borrower, whereas, net interest is just
one part of gross interest which is paid exclusively for the
use of capital. According to Keynes, interest is purely a
monetary phenomenon and its rate is determined by the
monetary forces of demand and supply. Interest is the reward
for capital and is the payment made to the supplier of
capital for the use of this factor in the process of production.
D - --
The Basic nan ial
Syst.em 3.3 BOND PRICE AND YIELD TO
MATURITY
Price of a bond moves inversely to the yield to maturity.
Therefore, the best approach to predict the bond price is to
first know its yield of maturity. The yields of maturity of all
bonds are dependent upon market interest rate, which
fluctuates frequently. These fluctuations arise from factors
which are internal as well a s external to the firm using the
funds.

1) Internal Factors :The probability that the investor in bond

might suffer from default or bankruptcy of the issuer is
called default risk. Default risk is that portion of a n
investment's total risk' that result from changes in the
financial solvency of the investment. For example, when a
company that issues security moves close to bankruptcy,
this change in the firm's financial solvency is reflected in
the market price of its securities. The variability of return
that investor experiences as a result of changes in the credit
worthiness of a firm that issues the investment securities
is their default risk. Default risk can be further divided
into: (i) business risk, and (ii) financial risk.

i) Business risk : It refers to the variability of operating

incomes or earning before interest and taxes. It is
influenced by demand variability, price variability and
operating leverage.
ii) Financial Risk : It represents the risk arising from the
use of debt capital. If the firm depends heavily on debt
capital, it will have high degree of financial risk exposure.
2) External Factors : These factors affect bonds simultan-
eously. Change in the supply a n d demand for credit,
changes in the macroeconomic environment (also called
m a r k e t r i s k ) are factors external to the individual
corporations, which affect their bond yield and prices. These
factors determine the level and structure of market interest
rates, and, thus, bond prices.

i) Purchasing Power Risk

a.
An increase in the amount of currency in circulation may
result in sharp and sudden fall in its value. Purchasing
power risk denotes the fact that an investor's money may
lose its purchasing power because of inflation. To understand
purchasing power, first, we will see how inflation can be
measured. Economists measure the rate of inflation by using
,
Priue Index, which is prepared by government agencies.
Such Price Index measures the cost of a representative
basket of consumer goods, which include food, clothing,
housing and health care products, which are bought by
26 average urban households. Prices of the goods change from
 month to month. The amount of that change is stated a s a Determinants of
Interest Rates
percentage and thus the resultant figure is that of inflation.
In other words it is the difference between the price i n d e ~
of a commodity in two months divided b y the price index in
the preuious month. Thus, we may call the inflation rate of
the month, which is converted into annual inflation. For
example if inflation is 1% then annual inflation will be
(1+1.0% per month)12 - (1.01)12 1.1268 + 12.68%

The goods which have strong demand will experience faster

rate of inflation than the goods that are not in strong
L
demand.

ii) Real Return/Nominal Return

I

After inflation is measured, it should be compared to

investment return. An investment's nominal rate of return
is money rates of return, that is, they are not adjusted for
the effect of inflation. Take up 9 numerical problem to
understand. We assume that a saving deposit earns a nominal
interest rate of 5% during one-year period. Thus, if Rs. 100
are deposited, it would grow to 100 (1 + 0.05) = Rs 105 in
a year. If we also assume that rate of inflation is 5% then
the real value (in term of current purchasing power) of Rs.
100 saving at end of the year is still 100 after we divide the
nominal rate by the inflation rate to get the real rate

100 (1.0 + 0.05/ 1.0 + 0.05) = Rs. 100

In this case, the nominal rate of return and inflation rate

are same. A wise investor should compare the inflation rate
with the nominal rate of return from different investment to
see if the investment's real rate of return is positive or
negative.

lnvestors should focus on real returns so as

, - i) to avoid being fooled by the money illusion fallacy, and

r ii) to detect those investments that will maximize their

purchasing power.

The saving's purchasing power will not increase even though

there will 5 percent more rupees in it.

iii) Market Risk

Market ups and downs are usually measured by using a

Security Market Index. When a security index rises fairly
1
consistently for a period of time, this upward trend is called
a Bull Market. The bull market ends when the market
index reaches a peak and starts a downward trend. The
period of time during which the market declines is called
Bear Market. Market risk arises from this variability in
I

I
market return, which results from the alternating bull and
The Basics of Financial bear market forces. The main element that causes the stock
System
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.

Market yield to maturity are determined by many things.

The most basic determinant of interest rate is what economists
call the real rate of interest, or the rate a t which capital
' grows in the physical sense. In addition to the real rate of
interest, market interest rate are also affected by various
risk premiums which investors may demand. In order to
undertake risky investments, lenders may requisite one or
more risk premiums to be paid over and above the real rate
of interest to induce them to lend their funds when the risk
of loss exist.

Since the interest rates and loans are typically in nominal

money quantities, rather than real physical quantities, the
nominal interest rate must contain a n allowance for the rate
of price changes so that lender's wealth is not be croded
away by inflation.

Level of interest rate is determined by

Nominal or market = real rate of interest + various

interest rate possible risk premium + expected
rate of return

Although, the rising rates of inflation push up the interest

rate, but sometimes, changes in interest rates are not related
to inflationary factors but, are result of various risk premiums,
changes in supply of and demand for loanable funds. During
a period of economic expansion, the unemployment rate
falls, business activity quickens and business needs more
money finance for purchase of machinery and to build bigger
plants. This results into higher interest rate. In contrast,
during slowdowns and recession, unemployment increases,
manufacturing activity slows and demand for credit decreases.
This results into fall in interest rate, if all other factors are
constant.

The oombined effect of changes in inflationary expectation

and changing credit market conditions causes the level of
market yield to vary over a wide range from year to year.
Any bond issuer usually has, on any given day, different
yield to maturity on its various bond issues, which will differ
in terms of maturity. For a given bond issue, the structure
of yield for bonds vary with different terms to maturity, but
no other difference is called term structure of interest rate.

When two bonds are alike or nearly so in all respects except

time to maturity, they usually set a t different yielld because
of the difference in their maturities. The relationship between
yield and maturity is known a s term structure of interest Determinants of
Interest Rates
rate. A plot of this relationship is known as yield curve
The level of inflatiohary expectations and the phase of
business cycle are two of the main factors, usually affecting
interest rates. But various kinds of risk premiums, which
rise and fall, can also have a n important effect on market
interest rates.
iv) Yield Spread

A yield spread is the difference between the promised yields

on any two bond issues or classes of bonds. Yield spread
may also be called risk premiums because they measure the
additional yield that risky bonds pay to induce investors to
buy more-risky bonds, rather than less risky bonds. Yield
spread, other than spreads between different maturities are
caused' primarily by difference in risk and taxability, but
they are also influenced by anything that affects the supply
of and demand for various kinds of bonds.
Risk premiums are higher when economic conditions are
not favourable. During recession, fear of job loss and risk
aversion are higher. Therefore, most investors demand large
risk premiums to induce them to buy risky bonds.
Secondly, the corporation which issues bonds, typically
experiences reduced sales and profits during recession: Since
the issuers are more subject to bankruptcy during recession,
investors require larger risk premiums.
Thirdly, the daily qale and purchase of bonds by bankers
and investment managers have a substantial impact on yield
spread. Most of these financial experts scrutinize the political
developments, which have economic financial implications.
When a country is involved in a war, it usually spends more
on war. Most governments finance their deficits by printing
new money which results into inflation which exerts harmful
effects upon the economy of the country.
Check Your Progress 1

1) What is the difference between Gross Interest and Pure

Interest?

2) State whether following statements are true or false?

i) There is a direct relationship between price of a bond

and its yield to its maturity. (T/F)
ii) Risk arising from the use of debt capital is known as
financial risk. (TIF)
 iii) Changes in macro-economic environment does not affect
the bond yield and prices. (7'1F)
3) How is the rate of inflation measured?
...........................................................................................

4) What do you understand by the term Yield Spread?

3.4 THE TERM STRUCTURE OF INTEREST

RATES
In addition to changes in the level of interest rate, which
arise due to changes in the rate of inflation, unusual risk
premiums, changing credit conditions, there are changes,
which are termed a s the 'term structure of interest rate'. For
a given bond issuer, the structure of yield for bonds with
different terms of maturity is called the 'term structure of
interest rates'. The term structure of interest rate', or 'yield
curve', as it is called, may be defined a s the relationship
between yields and maturities of bonds in given default risk
classes. The relationship is usually presented graphically a s
Yield Curve'. The yield curve changes a little everyday and
there are different yield curves for each class of bonds. The
yield curve for the riskier classes of bonds are at a higher
level than the yield curve for less risky bonds. The difference
in levels is due to the difference in risk premium. The yield
curves for risker bonds are not so stable.

There are two types of yield curves as presented in figure

(A) and (B). On the vertical axis in both the figures, 'yield
to maturity from a security is drawn, whereas, on the
horizontal axis time to maturity is drawn. There is a positive
relationship between the yield to maturity and the time to
maturity, if yield to maturity increases as, time to maturity
increases. This positive relationship between yield to maturity
and time to maturity is shown in figure (A), and the yield
curve obtained from this relationship is called as 'nornial'
yield curve'. The 'normal yield curve' is called so, because
it is more common.

However, sometimes, the relationship between the yield to

maturity and time to maturity is not positive. tThis results
in a downward sloping yieid curve (as shown in figure B).
This downward, sloping yield curve is known a s 'inverted
yield curve'.
 Yield I Determinants
Interest Rat
Yield to
to
Maturity
- /-
Time to Maturity
(A)
Maturity

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 ) The Liquidity Preference Theory

According to Liquidity Preference Theory, lenders prefer

short-term securities over long term securities, unless the
yield on the longer-term securities are high enough to
compensate for the greater interest rate risk. Risk is related
to variability of return or dispersion of market value. So
interest rate risk increases with term to maturity of a bond.
The long-term bonds have more interest rate risk than short-
term bonds because of their long duration and because
their interest elasticity is larger. A s a result, the prices of
long-term bonds fluctuate more than the prices of short-
term bonds. The large price fluctuations are the basis of
liquidity premium hypothesis.

Unlike lenders, borrowers show a preference for long-term

securities. They (borrowers) will borrow on a relatively short-
term securities only if these are available a t smaller interest
rates.

Thus, generally, lenders are averse to long-term securities

(because of the higher risk involved), and borrowers are
averse to short-term securities. These aversions on the part
of lenders and borrowers influence the term structure of
The Basics of Financial interest rates. However, the term structure on interest rates .
System
is likely to vary over time, as the degree of these aversions
varies. Thus, the degree of these risk aversions influences
the shape of yield curve also. With a n increase in the risk
aversion on either or both the parties, yield curve moves
upward and vice-versa. However, Cooper and Fraser (1990)
noticed that, liquidity preference, by itself, couldn't account
for a downward sloping yield curve. Maturity preferences by
the borrowers and lenders, their expectation regarding future
yields etc, are other explanatory factors. However, there are
other theories, which have attempted to identify these factors.
: These theories are discussed as follows.
2) Expectations Theory

The Expectation theory hypothesises t h a t investors'

expectation alone shape the yield curve. This theory assumes
that the yield on a long-term bond is a n average of the
short-term yields that are expected to prevail over the life
of the long-term bond. Its validity rests on the assumption
that investors are indifferent to any variation in risks
associated with different maturities. They consider long term
and short-term bonds to be perfect substitutes for one
another, and, therefore, move freely from one maturity to
another always looking for highest expected return. This
implies that when all investors expect the rates to -

i) rise, the yield curve would slope upward

ii) remain unchanged, the yield would be horizontal or
iii) fall, the yield curve would slope downward.

3) Market Segmentation Theory

Accocding to market segmentation theory, interest rates for

various maturities are determined by demand and supply
conditions in the relevant segments of the market. Investors
are not indifferent to difference in maturities. Instead they
have definite maturity preferences, which are based largely
on the nature of their business.

For example, using the simple arithmetic average if 1" year

rate is 10% and it is expected to be 11% next year, then the
rate on two-year bond will be approximately 10.5%

If we assume forward interest rate that we expect to exist

in 3 year ahead is 15% then bond rate will be approximately
12%

The interkst rates are generally referred to as spot and

forward rates. Forward rate refers to yield to maturity for
 bond which is expected to exist in future: Whereas, spot Determinants of
Interest Rates
rate refers to the interest rate for bond, which currently
exists and is being currently bought and sold. Forward rates
are implicit. These rates cannot be observed, whereas, spot
rates can be observed.
This theory is also referred to as 'hedging theory'. The
implication is that investors' decisions are typically affected
by the particular pattern of their liabilities. Given the
maturity of investors' liabilities, he or she can hedge against
capital loss in the bond market by synchronizing asset with
liability maturities. Thus, each investor remains confined to
some maturity segment, which corresponds to his or her
liability maturities.

Some bond portfolio panagers attempt to increase their

portfolios' yield by undertaking a bond investment strategy
called 'riding the yield curve'. This strategy may be
undertaken whenever the yield curve is upward sloping
(that'is the long term rates are higher than the short term
rates) regardless of whether the yield curve is smooth or
kinky .
Riding the yield 'curve is a buy and hold strategy, in which
the bond investbr purchases a n intermediate or long term
bond when the yield curve is sloping upward and is expected
to maintain {his slope and level. The purchased bond is
simply held in order to obtain capital gains that occurs as
the bond move closer to the maturity date and thus rides
down the yield curve. That is in addition to the coupon rate.
Bond investor earns capital gains. Of course, danger in this
strategy is that the level of interest rates may rise or that
the short-term end of the yield curve may wing upward.
A compilation of all these theories furnishes the best
description of the elements of determining the 'term structure
of interest rate'.
I.

Check Your Progress 2

1) What
b
do you mean by 'term structure of interest rates?

2) 'State whether following statement are true or false:

i) According to Liquidity Preference Theory, interest rate

increases with term to maturity of a bond. (T/F)
ii) According to Expectation T h e o e of Interest, yield on a
long-term bond is an average of the short-term yield,
expected to prevail over the life of the long-term bond.
(T/ F)
 r-

The Basics of Financial iii) The yield curve slopes upward in the event of falling
System
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)

3 . 5 FACTORS AFFECTING MARKET

INTEREST RATES
There are many interest rates in the market and they do
not always move in the same direction or to the same
extent. Therefore, it is sometimes useful to select one rate
to represent the short-term market. I t is commonly believed
that four factors are dominant in determining interest rate
levels. These are state of economy, monetary policy, inflation
expectations and federal budget.

Three other factors that can be important are:

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

Interest rates have a tendency to move u p and down with

changes in the volume of business activities. In period of
rapid economic growth, business firms require large amount
of capital to finance increased requirements of in working
capital and fixed asset. The business demand for borrowed
funds, combined with increase in consumer borrowing put
upward pressure on interest rates.

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

Bank rate is the rate a t which the central bank of a country

provides loans to the commercial banks. Bank rate is also
called the discount rate because in the earlier days, the
central bank used to provide finance to the commercial Determinants of
banks by rediscounting their bills of exchange. Interest Rates

Through change in the bank rate, the Central Bank can

influence the creation of credit by the commercial banks.
When the Central Bank raises the cost of borrowing, the
bank rate would rise. When bank rate is raised, the
commercial banks also raise their lending rates. When the
rate of interest charged by commercial banks are high,
businessmen are discouraged to borrow more. This would
tend to contract bank credit and hence would result in
reduced aggregate demand for money. This would reduce
prices and check inflation or rising prices. On the other
h a n d , by lowering the b a n k rate, the Reserve Bank
encourages or induces the commercial bank to borrow more
funds from it. This enhances their capacity to make more
credit available to the businessmen.

ii) Open Market Operations

The term 'open market operation' means the purchase and

sale of securities by the Central Bank of the country. The
sale of securities by the central bank leads to contraction
of credit and purchase of securities that leads to credit
expansion. When the economy is in the grip of depression,
purchase of securities by central bank from the open market
is called for. The central bank will pay the price of the ,

securities to the sellers, which are generally the commercial

banks. As a result of this, the quantity of cash a t the
disposal of commercial banks will go up and they will be in
a position to expand credit to the businessmen. With this,
the aggregate demand will increase which will help to cure
depression. On the other hand, during inflation the central
bank sells the securities and thereby contracts money supply.

iii) Cash Resenre Ratio (CRR)

A cash reserve is the fraction of total deposits of the banks,

which is required to keep a s deposit with RBI. When RBI
wants to contract credit or lending by banks, it raises the
CRR. On the other hand, when it wants to increase the
availability of credit, it lowers the CRR.

iv) Supply of Money

One of the primary objectives is to achieve stable economic

growth with a low rate of inflation. Generally the faster the
I ( gz11 rcserves are allowed to grow, the greater the volume
of lending, the fidster the growth rate of money supply. If the
supply of money grows faster than the needs of the economy
[or a considerable period of time, nominal interest rates will
rise due to an increase in the rate of inflation
The Basics of Financial 3) Expected rate of Inflation
System
Purchasing power risk arises from unanticipated inflation. It
is the risk that the rate of inflation will be greater than the
investor expected when the investment was made causing
the real rate of return to be lower than expected. Because
of these risks, market interest rates and other required
returns include an inflation premium.

4) Government Deficit

Increase in government securities, unless offset by decreases

in other borrowing means an increase in the total demand
for loanable funds. There is a positive correlation between
the amount of government deficit and the money supply:

3.6 EFFECT OF CHANGES IN INTEREST

RATES
The basic argument of interest rate policy is that a rise in
the interest rate raises the cost of credit and thus discourages
investment a s well a s consumption finqnced with loans. On
\
the other hand, lowering of the rate of interest cheapens
t h e cost of credit a n d t h u s encourages investment
expenditure a s well a s consumption expenditure. Hence,
the interest rate policy can be used a s a contra cyclical
measure.
A change in the short-term rate of interest can be brought
about by changing the bank rate, the rate a t which the
Central Bank f; a . country discounts the first rate short-
term bills of exchange. It is assumed that a change in the
bank rate directly influences the rate of interest charged by
the comm'ercial banks on their advances, a s well a s the
other short-term interest rates, such as those charged for
money a t call, bill discounted, hire purchase finance etc.
However, the short-term rate of interest is relevant to
investment in inventories. A change in this rate is not likely
to influence it significantly, as interest cost constitutes only
a small part of the total cost. Similarly, it may not affect the
consumption facilitated by purchase, provident fund
contributions and insurance premium.
: A change in the short-term rate of interest can effectively
change t h e value of credit taking some factors into
consideration. This can be explained by a n example o f t
increasing short-term rate of interest with a view to control
inflationary situation. It will give rise to following difficulties:

1) It will add to the balance of payment difficulties a s current

account by increasing the cost of short term borrowing from
. abroad.

46 2 ) It will increase the cost.of serving the national debt.

 Determinants of
3) It may also tend to pull up the long term rate of interest as Interest Rates
people may begin to expect rise in the long term rate of
interest, and thus, they may begin to sell long- term
securities in consequence of which their prices will fall and
long-term rate of interest yielded by them will rise.

;neck Your Progress 3

1) What is bank rate?

2 ) Why are the open market operations resorted by the Central

Bank?

3) What type of relationship exists between amount of ,

~overnmentdeficit and money supply?

1) How does the rate of interest influence the consumption

and investment?

3.7 LET US SUM UP

Borrowing and lending in the financial market, to a
significant extent, depends on the rate of interest. There
are four elements of gross interest: payments for risk,
payment for inconvenience, payment for management,
payment for exclusive use of money. The fourth component
i.e. the payment for the use of money is known a s Pure
Interest.

Price of a bond moves inversely to the yield to maturity. The

yield of maturity of all bonds depend upon interest rate
which fluctuate frequently. Fluctuations in the bond interest
rates are caused by the internal factors namely, default
risks, business risks and financial risks, and external factors
i.e. purchasing power risk and market risks. Three theories
have been promoted to explain how the shape of yield curve
The Basics of Financial is determined. These are: the Liquidity Preference Theory,
System
Expectation Theory and Market Segmentation Theory.
These theolries have furnished the description of the
elements, which determine the term structure of interest
rate. Many interest rates are found in the market and they
do not necessarily move in the same direction. The reasons
behind many interest rates in the market are economic
condition, monetary policy, inflation expectation and federal
budget.

Interest rate significantly influences the investment and

consumption. Rise in the interest rate raises the cost of
credit and discourages the investment expenditure, a s well
as consumption expenditure. On the other side, lowering
of interest rate reduces the cost of credit, and thus,
encourages the investment and consumption expenditure.

KEY WORDS
Bear Market : A market in which prices of shares'
and commodities are decreasing.

Boom : Refers to a period of expansion of

business activity. A boom reaches a
peak when the economy has been
working a t a full capacity.

Bond : A security issued by a Government,

Government agency, or a private
company as a m e a n s of raising
money.
Bull : A person who expects prices, especi-
ally of shares and commodities, to rise.

Bull Market : A market in which prices are rising

enabling bulls to operate profitably.

Depression (Slum) : The stage of trade cycle character-

ising decreasing prices, output ,I * !d
employment and thus, under-ur i I sa-
tion of all factors of productiol!

Financial Capital : Funds made available for purc t 1nse

of capital assets is called financial
capital.
Inflation : Inflation refers to a tendency of
persistent rise in prices over a period
of time.

Yield : Yield measures the annual income

from an investment against its current
 market price. Yield falls when prices Determinant. of
,
Interest Rates
rise.
Yield Curve : Graph showing the return on fixed
interest securities according to their
maturity.

3.9 SOME -USEFUL BOOKS

Hendrik, S. Houthakker & Peter, J. Williamson (1996): The
Economics of Financial Markets, Oxford University Press,
Chapter 6, Page 141-167.
Bhole, L,M (1992): Financial Institutions and Markets, Tata
McGraw Hill Publications, New Delhi, Chapter 22 Page 447-
464.
Cooper, S. & Fraser, D.R. (1990): The Financial Market
Place, IIIrd Edition, Westley Publishing Company, Massachuales,
New York, Chapter 7, Page 156-182.

3.10 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Gross interest is a wider term. Pure interest is a part of
gross interest which refers to the payment made for the
use of capital. Gross payment is the total payment the
lender gets from the borrower.
2) (i) False (ii)True (iii) False
3) The inflation is measured by the Price Index prepared by
the Government agencies.
4) See Section 3.4
Check Your Progress 2
1) 'Term structure of interest rates' refers to the structure of
yield for bonds with different terms of maturity.
2) (i) True (ii) True (iii) False (iv) True
Check Your Progress 3
1) The rate a t which the Central Bank of a country provides
loans to the Commercial Banks.
2) A s a measure to cure the depression and inflation.
3) Direct.
4) The higher interest rate raises the cost of credit and thus,
discourages investment as well as consumption. On the
other hand, lowering of the interest rate cheapens the credit
and thus, increases the investment expenditure.