interest rate structure in an economy

8/8/2019 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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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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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

interest rate structure in an economy

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