Download - Interest Rate Structure in an Economy
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Understanding interest
rates
-------- Bala
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Concept of interest
Compensation for investing in bank
deposit or bond or fixed deposit of
companies or debentures Compensation for what?
For use of money by the acceptor
For not being able to use the money by the
giver
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Concept of interest 2
Is there any specific name given to the
loss borne by the giver (depositor or
investor)? Yes it can be named as opportunity
cost
Opportunity cost means the loss borne by an
investor by foregoing investment in a specific
instrument or sector etc.
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Opportunity cost
An example of opportunity cost
Suppose there are two alternative investmentoptions available to an investor investing insecurities @ 12% p.a. return and investing inland at expected rate of return of 25% p.a.
In this case if the investor chooses option 1, heis said to have suffered an opportunity cost of13% p.a.
Note: Net opportunity cost = Difference in ratesof return between two alternative investmentoptions
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Universality of Interest
Paid all over to all types of investors insecurities other than equity or preferenceshare capital
Equity or preference share capital begetsdividend that is post-tax
Islamic law does not permit reward of
interest on investment. Hencecompensation has to be in a different formin nations that follow Islamic banking
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Interest paid on what?
Fixed deposit with banks or limited
companies
Bonds Debentures
Loans
Overdraft Cash credit
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Basic factor influencing rate of
interest Rate of inflation in an economy
That is why interest rates differ from country to
country as rate of inflation differs from country to
country
For example, in India it is around 10.5% at
present whereas in the U.S. it is around 3.5%
Usually the higher the degree of development ofa country, the less the rate of inflation and vice-
versa
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Tiered structure for rates of
interest Tier 1 = Rate of inflation = 10.5%
Tier 2 = Rate of interest on investment =
Rate of inflation + some compensation If this were to be true then rate of interest
on bank deposit in India should be higher
than 10.5%; it is not so.
How is this explained?
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Explanation for the low deposit
rate in India at present Rate of interest on bank deposit till say
one and a half years ago was higher than
rate of inflation 8.5% vs. 6 to 7% rate of
inflation
However this was impacted due to sudden
rise in inflation in this period; deposit rates
could not cope up with the spurt in inflationin India
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Is that an aberration?
In a manner of speaking an aberration
Why so?
If investors are not attracted to savings indeposits, then there will be more
consumptive spending
This will push up the rate of inflationfurther
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Constraint on banks increasing
rateso
n depo
sits? Past low to moderate rates of inflation
result, ability to give loans at low tomoderate rates
Constraint on increasing rates of intereston loans consequent to sudden increasein inflation; there are legal agreements
between borrowers and banks Banks can give only fresh loans at ahigher rate consistent with rate of inflation
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Constraint on increasing deposit
rate 2 Definite linkage between the average rate
of interest on deposits & average rate ofinterest on loans
Because banks can pay interest to theirdepositors only from interest that they earnon loans
Constraint on increasing increase rate ofinterest on loans, reflected in constraint onincreasing rate of interest on deposits
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Tiered structure for rates of
interest 2 Tier 2 = Rate of inflation + some additional
compensation as an incentive
Tier 3 = Weighted average cost of fundsfor lender + administrative expenses +profit
The rate has to be competitive How?
Concept of PLR for short-term lending Tier 4 = Rate of return from a project
investment
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Tiered structure for rates of
interest 3 Tier 4 = Weighted average cost of capital
+ Risk premium including profit
As can be seen, the risk premium dependsupon: Sector &
Expectation of promoters from the sector
Note: Expectation of promoters from thesector depends upon their corecompetencies, where they lie?
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Summary of4 tiers in interest
rate structure Tier 1 = Rate of inflation
Tier 2 = Rate of return on an investment
Tier 3 = Rate of interest on loan Tier 4 = Rate of return from project
investment
Note: Each successive tier includes therate of the previous tier
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Nominal and real interest rates
Nominal = the rate of interest indicated on
an investment instrument, say 10.5% p.a.
at present
Real = Difference between the nominal
rate of interest and rate of inflation
At present real interest rate = Zero
Nominal rate = 10.5% p.a. and rate of
inflation = 10.5%
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What does it indicate?
There is no gain for the investor at all in
investing in banks deposits at the moment
How can it improve? By control over inflation and retaining the
bank deposit rates for some more time
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Nominal and effective interest
rates Nominal rate once again as mentioned in thedeposit receipt, say 10% p.a.; period 36 monthsand half yearly compounding
Effective rate of interest:
Refer to the formula worked out during theclass
Effective rate of interest is the average rate peryear after giving the effect of compounding to a
nominal rate Note: Effect of compounding depends upon
frequency of compounding
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Fixed and floating rates of
interest How does a lender protect against marketfluctuation in rates of interest?
By offering both on deposits and loansfloating rate option besides conventionalfixed rate option
What does floating rate mean?
It means that if market rates go up, theborrower has to pay higher rate of intereston his loan
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Fixed and floating rates of
interest 2
How does it benefit a depositor?
Similarly a depositor will get a higher rate
of interest in case the market rates go up Is there a flip side to this arrangement?
Obviously; the depositor will lose in case
the market rates come down while alender will gain
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How does one choose fixed or
floating rate?
A depositor would choose a floating rate incase in his estimation, the rate of interestis likely to go up
Similarly a borrower would choose afloating rate in case in his estimation, therate of interest is likely to come down
Banks in India adjust the rate in the caseof floating rate arrangement, once in aquarter
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At a time will fixed and floating
rate differ?
Yes. The fixed rate will always be higherby one per cent than the correspondingfloating rate. This is to induce borrowers to
go in for floating rate Does it mean that fixed rate does not
change at all?
It will change only for new borrowers; if themarket rate goes up, a new borrower willget at a higher fixed rate
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Switch fromfixed tofloating and
vice-versa
Can a borrower switch from floating to
fixed and vice-versa?
Yes. No problems. Only that the borrowerhas to incur one time cost for this switch
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Determination offloating rate of
interest
For floating rate of interest, there is always abench mark rate
Bench mark rate depends upon the nature of
loan short-term, medium-term or long-term Well-known benchmark rates:
LIBOR, global short-term to medium-term
MIBOR in India short-term
Yield on long-term bonds in India Long-term
Yield on medium-term bonds in India Medium-term
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How is floating rate determined?
By loading so many basis points on to the
bench mark rate
1 basis point = 1 per cent of 1 per cent; inother words, 0.01%
Suppose base rate is 9.5% p.a. and load
factor is 75 basis points
Then the floating rate would be:
9.5% (+) 0.75% = 10.25% p.a.
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What is the speciality ofLIBOR?
Full form = London Inter-bank offer or
operating rate
It is universally accepted for all the majorcurrencies in the world
Rate keeps on changing every day
Rate depends upon: Currency for lending &
Duration of lending
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How is interest amount actually
determined?
By adopting one of the two methods:
On a daily product basis
On a monthly product basis Please refer to the exercises done in the class
to understand the difference
Daily product basis, usually adopted for loan,
cash credit, bill discounted or overdraft Monthly product basis, usually adopted for
deposits like Savings bank
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Money market instruments
Interest on them
All money market instruments interest isincluded in the maturity value
Suppose one treasury bill is for Rs. 1crore, this value includes interest payablefor the period
What does it mean?
This means that Rs.1 crore, as reduced byinterest payable in future is collected at thetime of investment
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MMI Interest on them
This kind of instrument is known as a
discounted value instrument
How is it done?
At a given rate say, 6.5% p.a., on a treasury bill
for 91 days, interest is determined on 365 days
basis and deducted from Rs.1 crore
Rs. 1 crore is the maturity value. Maturity value(-) interest as above = amount of investment