Understanding Interest Rates in the financial institution

Interest is the price demanded by the lender from the borrower for the use of borrowed money. In
other words, interest is a fee paid by the borrower to the lender on borrowed cash as a
compensation for forgoing the opportunity of earning income from other investments that could
have been made with the loaned cash. Thus, from the lender’s perspective, interest can be
thought of as "rent of money" and interest rate as the rate at which interest accumulates over a
period of time. The longer the period for which money is borrowed, the larger is the interest.
The amount lent is called the principal. Interest rate is typically expressed as percentage of the
principal and in annualized terms. From a borrower’s perspective, interest rate is the cost of
capital. In other words, it is the cost that a borrower has to incur to have access to funds.
Interest rates also affect the economic decisions of businesses and households such as whether to
use their funds to invest in new equipment for factories or to save their money in a bank.
Factors affecting the level of Interest Rate
Interest rates are typically determined by the supply of and demand for money in the economy.
If at any given interest rate, the demand for funds is higher than supply of funds, interest rates
tend to rise and vice versa. Theoretically speaking, this continues to happen as interest rates
move freely until equilibrium is reached in terms of a match between demand for and supply of
funds. In practice, however, interest rates do not move freely. The monetary authorities in the
country (that is the central bank of the country) tend to influence interest rates. Broadly the
following factors affect the interest rates in an economy:
Monetary Policy – The central bank of a country controls money supply in the economy
through its monetary policy. In Ethiopia, for example, the NBE’s monetary policy primarily aims
at price stability and economic growth. If the NBE loosens the monetary policy (i.e., expands
money supply or liquidity in the economy), interest rates tend to get reduced and economic
growth gets spurred; at the same time, it leads to higher inflation. On the other hand, if the NBE
tightens the monetary policy, interest rates rise leading to lower economic growth; but at the
same time, inflation gets curbed. So, the NBE often has to do a balancing act.
Growth in the economy – If the economic growth of an economy picks up momentum, then the
demand for money tends to go up, putting upward pressure on interest rates.
Inflation – Inflation is a rise in the general price level of goods and services in an economy over
a period of time. When the price level rises, each unit of currency can buy fewer goods and

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services than before, implying a reduction in the purchasing power of the currency. So, people
with surplus funds demand higher interest rates, as they want to protect the returns of their
investment against the adverse impact of higher inflation. As a result, with rising inflation,
interest rates tend to rise. The opposite happens when inflation declines.
Uncertainty – If the future of economic growth is unpredictable, the lenders tend to cut down on
their lending or demand higher interest rates from individuals or companies borrowing from
them as compensation for the higher default risks that arise at the time of uncertainties or do
both. Thus, interest rates generally tend to rise at times of uncertainty.
Classification of Interest Rates
Different types of classifications of interest are possible. Based on how interest is computed,
interest is classified into simple interest and compound interest.
Simple Interest: Simple interest is calculated only on the principal amount which has not yet
been paid. It is calculated by using the formula

I =P x r x t

Where; I is the simple interest to be paid,

r is the interest rate per annum,
t is the time period expressed in years for which interest is being calculated
P is the principal amount not yet paid back.
Note the difference between I and r. ‘I’ refers to interest income or simply interest, while ‘r’
refers to interest rate. It can be easily seen that the simple interest over 2 years on a given
principal is equal to double the simple interest in one year; over three years, it is equal to three
times the simple interest in one year and so on.
Compound Interest: Compound interest arises when interest is added to the principal, so that
the interest that has been added also earns interest for the remaining period. This addition of
interest to the principal is called compounding (i.e. the interest is compounded). A loan, for
example, may have its interest compounded every month. This means a loan with Br 100 initial
principal and 1% interest per month would have a balance of Br 101 at the end of the first month,
Br 102.01 at the end of the second month, and so on. So, the interest in the first month is Br 1,
while the interest in the second month is Br 1.01. The frequency with which interest is
compounded varies from case to case; it could for example be monthly or quarterly or half-
yearly or annually and so on.
In order to define an interest rate fully, and enable one to compare it with other interest rates, the
interest rate and the compounding frequency must be disclosed. Since most people prefer to
think of rates as a yearly percentage, many governments require financial institutions to disclose
the equivalent yearly compounded interest rate on deposits or advances. This equivalent yearly
rate may be referred to as annual percentage rate (APR), annual equivalent rate (AER), annual

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percentage yield, effective interest rate, effective annual rate, and by other terms. For any given
interest rate and compounding frequency, an "equivalent" rate for any different compounding
frequency exists.
For example, if interest at 8% is compounded quarterly for one year on a principal amount of Br.
10,000 the total interest (compound interest) would be Br. 824.32, as computed below:
Period Principal x Rate x Time = Compound Interest Accumulated Amounts
1st quarter--------- Br. 10,000 x 0.08 x ¼ Br. 200.00 Br. 10,200.00
2nd quarter -------------10,200 x 0.08 x ¼ 204.00 10,404.00
3rd quarter -------------10,404 x 0.08 x ¼ 208.08 10,612.08
4th quarter ---------10,612.08 x 0.08 x ¼ 212.24 10,824.32
Interest 824.32

Note; In computing of compound interest, the accumulated amount at the end of each period
becomes the principal amount for purposes of computing interest for the following period.

One other way in which interest rates can be classified is in terms of fixed interest rates and
floating interest rates:
Fixed Interest Rate: If the rate of interest is fixed at the time the loan is given and remains
constant for the entire tenure of the loan, it is called fixed interest rate.
Floating Interest Rate: Interest rates on commercial loans given to companies or individuals
often fluctuate over the period of the loan. Also, loans may have an interest rate over the life of
the loan linked to some reference rate, such as PLR (Prime Lending Rate), which varies over
time. For example, interest rate on a loan can be fixed at PLR plus 2 percent. As the PLR
changes, the interest rate on the loan would change. In such cases, the interest rates are said to be
floating rate, or variable rate

 Four Types of credit market instruments

In terms of the fining of their cash flow payments, there are four basic types of credit market
instruments.
A. A simple loan, which we have already discussed, in which the lender provides the
borrower with an amount of funds, which must be repaid to the lender at the maturity date along
with an additional payment for the interest. Many money market instruments are of this type for
example, commercial loans to businesses.
B. A fixed-payment loan (which is also called a fully amortized loan) in which the lender
provides the borrower with an amount of funds, which must be repaid by making the same
payment every period. ( such as a month) , consisting of part of the principal and interest for a set
number of years for example, if you borrowed $ 1,000, a fixed payment loan might require you

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to pay $ 126 every year for 25 years, Installment loans ( Such as auto loans ) and mortgages are
frequently of the fixed payment type.
C. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment )
every year until the maturity date, when a specified final amount ( faceable or par value ) is
repaid. A coupon bond with $ 1,000 face value, for example, might pay you a coupon payment
of $100 Per year for 10 years, and at the maturity date repay you the face value amount of $
1,000.

A coupon bond is identified by three pieces of information. First is the corporation or

government agency that issues the bond. Second is the maturity date of the bond. Third is the
bond coupon rate, the dollar amount of the yearly coupon payment expressed as a percentage of
the face value of the bond. In our examples the coupon bond has a yearly coupon payment of
$100 and a face value of & 1,000. The coupon rate is them $100/$1,000 = 0.10 or10%. Capital
market instruments such as U.S Treasury bonds and notes and corporate bonds are examples of
coupon bonds.
D. A discount bond; also called a zero –coupon bonds is bought at a price below its face value
(at a discount) and the face value is repaid at the maturity date unlike a coupon bond, a discount
bond does not make any interest payments, it just pays off the face value. For example, a one –
year discount bond with a face value of $1,000. U. S treasury bills, U. S savings bonds, and long-
term zero coupon bonds are examples of discount bonds.
These four types of instruments require payments at different time’s simple loans and discount
bonds make payment only at their maturity dates, where as fixed payment loans and coupon
bonds have payments periodically until maturity.

CHAPTER THREE

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 FINANCIAL MARKET IN THE FINANCIAL SYSTEM
Financial markets ( bond and stock markets ) and financial intermediaries ( banks, insurance
companies, pension funds) have the basic function of getting people together by moving funds
from those who have a surplus of funds to those who have a shortage of funds. More
realistically, when Apple invents a better ipod, it may need funds to bring its new product to
market. Similarly, when a local government needs to build a road or a school, it may need more
funds than local property taxes provide. Well functioning financial markets and financial
intermediaries are crucial to economic health.
To study the effects of financial markets and financial intermediaries on the economy, we need
to acquire an understanding of their general structure and operation
The organization of markets
A Market is an institutional mechanism where supply and demand meet to exchange goods and
services; or a place or event at which people gather in order to buy and sell things in order to
trade. Exciting with many different functions, the financial system fulfills its various roles
mainly through markets where financial claims and financial services are traded (though in some
least-developed economies Government dictation and even barter are used). These markets may
be viewed as channels through which moves a vast flow of loan able funds that continually being
drawn upon by demanders of funds and continually being replenished by suppliers of funds.
The role of markets in an economy
The financial markets perform a vital function within the economic system. The financial
markets channel savings which come mainly from households to those individuals and
institutions who need more money (funds) for spending than are provided by current income. It
is known that the basic function of any economy is to allocate scarce resources in order to
produce the goods and services needed by society.
(Circular flow production and payment)

Land and other

Natural resources Goods and Services
Flow of Sold to the public
Labor and managerial skills Production
Capital equipment
Flow of
Payments

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The diagram shows that the system is just a circular flow between producing units (mainly
business and government) and consuming units (mainly households). In modern economies,
households provide labor, management skills, and natural resources to business firms and
governments in return for income in the form of wages, rents and dividends. Therefore, one can
see that markets are used to carry out the task of allocating resources which are scarce relative to
the demand of the society. Here we are referring to the markets which are different from the
financial markets; the goods market and the factor markets. The following sections discuses the
essential three types of markets at work within the economic system.
The Structure of Markets
It is known that the basic function of any economy is to allocate scarce resources in order to
produce the goods and services needed by society. There are three types of markets: Factor
markets, Product market and financial markets.
a) Factor markets: - are markets where consuming units sell their labor, management
skill, and other resources to those producing units offering the highest prices. i.e.
this market allocates factors of production (Land, labor and capital – and distribute
incomes in the form of wages, rental income and so on to the owners of productive
resources.
b) Product market: - are markets where consuming units use most of their income from
the factor markets to purchase goods and services i.e. this market includes the
trading of all goods and services that the economy produces at a particular point in
time.
c) Financial markets: - There are markets in which flow of funds, flow of financial
services, income and financial claims is affected i.e. essentially; financial markets
do have three main tasks. These are:
1. They determine the nature of credit available at a macroeconomic level;
2. They attract savers and borrowers; and
3. They set interest rate and security prices.
Allocating resources which are scarce relative to the demand of society, one can see that the
market place determines what goods and services will be produced and in what quantity. This is
accomplished mainly through changes in the prices of commodities and services offered in the
market. In addition, it is easy to understand that markets also distribute income. Markets provide

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superior productivity, innovation and sensitivity to consumer needs with increased profits, higher
wages and other economic benefits.

Importance of Financial Markets in the Economy

Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income. The principal
lender-savers are households, but business enterprises and the government (particularly state and
local government), as well as foreigners and their governments, also sometimes find themselves
with excess funds and so lend them out.
The most important borrower-spenders are businesses and the government but households and
foreigners also borrow to finance their purchases of cars, furniture, and houses. The first way is
the direct finance, in which borrowers borrow funds directly from lenders in financial markets by
selling them securities (also called financial instruments), which are claims on the borrower’s
future income or assets.

The second route is called indirect finance, because it involves a financial intermediary that
stands between the lender-savers and the borrower-spenders and helps transfer funds from one to
the other. A financial intermediary does this by borrowing funds from the lender-savers and then
using these funds to make loans to borrower-spenders. For example, a bank might acquire funds
by issuing a liability to the public (an asset for the public) in the form of savings deposits. It
might then use the funds to acquire an asset by making a loan to firms or by buying a bond in the
financial market. The ultimate result is that funds have been transferred from the public (the
lender-savers) to the borrower-spender with the help of the financial intermediary (the bank).
The process of indirect finance using financial intermediaries called financial intermediation is
the primary path for moving funds from lenders to borrowers.
Why is this channeling of funds from savers to spenders so important to the economy?

The answer is that the people who save are frequently not the same people who have profitable
investment opportunities available to them, the entrepreneurs. Without financial markets, it is
hard to transfer funds from a person who has no investment opportunities to one who has them;
both of them would be stuck with the status quo, and both would be worse off. Financial markets

7
are hence essential to promoting economic efficiency. Thus financial markets are critical for
producing an efficient allocation of capital, which contributes to higher production and
efficiency for the overall economy.
Well-functioning financial markets also directly improve the well-being of consumers by
allowing them to time their purchases better. They provide funds to young people to buy what
they need and can eventually afford without forcing them to wait until they have saved up the
entire purchase price. Financial markets that are operating efficiently improve the economic
welfare of everyone in the society.
Formation of Financial Markets within the Financial System
Depending on the characteristics of financial claims being traded and the needs of different
investors, the flow of funds through financial markets around the world may be divided into
different segments. These include: The Money Market and Capital Market; Primary and
Secondary Markets; Open and Negotiated Markets as well as Spot; Futures, Forward, and
Option Markets.

The Money Market versus the Capital Market

Money is a medium of exchange which ensures the success of exchange by being the one item
on offer that is always acceptable. Money is necessary because human beings must exchange to
live together in peace, and to prosper.
Money is the good that people do not want to consume, but want to use to make further
exchanges easier. Money in its modern form - coin of fixed weight and denomination - came into
use less than three thousand years ago. It took a long time to discover the physical good which
best serves the purpose of a medium of exchange.
Money can be used as direct exchange, or barter, is exactly that - my good or service for your
good or service.
Money is any marketable good used by a society as a store of value, a medium of exchange, or a
unit of account. Money objects can meet some or all of these needs. Since the needs arise
naturally, societies organically create money object when none
exists. In other cases, a central authority creates a money object; this is more frequently
the case in modern societies with paper money.

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One of the most important divisions in the financial system is between money market and the
capital market. The money market is designed for the making of short-term loans. It is the
institution through which individuals and institutions with temporary surpluses of funds meet the
needs of borrowers who have temporary funds shortages (deficits). Thus, the money market
enables economic units to manage their liquidity positions.
By conventions, a security or loan maturing within one year or less is considered to be a money
market instrument. One of the principal functions of the money market is to finance the working
capital needs of corporations and to provide governments with short-term funds in lieu of tax
collections.
In other words, the money market is the global financial market for short-term borrowing and
lending. It provides short-term liquid funding for the global financial system. The money market
is a sector of the capital market where short-term obligations such as Treasury bills, commercial
paper and bankers' acceptances are bought and sold.
A money market consists of financial institutions and dealers in money or credit who wish to
either borrow or lend. Participants borrow and lend for short periods of time, typically up to
twelve months.
In contrast, the capital market is designed to finance long-term investments by businesses,
governments and households. Trading of funds in the capital market makes possible the
construction of factories, highways, schools, and homes. Financial instruments in the capital
market have original maturities of more than one year and range in size from small loans to
multimillion Birr /Dollar credits.
The capital market includes the stock market, the bond market, the primary market and the
capital market. Securities trading on organized capital markets are monitored by the government;
new issues are approved by authorities of financial supervision and monitored by participating
banks. This market brings together all the providers and users of capital.

Financial intermediaries, such as banks, brokerage firms, and insurance companies facilitate the
transfer of capital.
The capital markets consist of the primary market, where new issues are distributed to investors,
and the secondary market, where existing securities are traded. So it is the market in which

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corporate equity and longer-term debt securities (those maturing in more than one year) are
issued and traded.
The capital market (securities market) is the market for securities, where companies and the
government can raise long-term funds. A security is a fungible, negotiable instrument
representing financial value. Securities are broadly categorized into debt and equity securities
such as bonds and common stocks, respectively. The company or other entity issuing the security
is called the issuer.

Who are the principal suppliers and demanders of funds in the money market and the capital
market?

In the money market, commercial banks are the most important institutional supplier of funds
(lender) to both business firms and governments. Non financial business corporations with
temporary cash surpluses also provide substantial short-term funds to the money market. On the
demand-for-funds side, the largest borrower in the money market is the Treasury Department,
which borrows billions of Birr frequently. Other governments around the world are very often
among the leading borrowers in their own domestic money markets. The largest and best-known
corporations and securities dealers are also active borrowers in money markets around the world.
Due to the large size and strong financial standing of these well-known money market borrowers
and lenders, money market instruments are considered to be high-quality ,”near money” IOUs (I
owe you) (promises to pay).
Governments rely on the capital market for funds to build schools and highways and provide
essential services to the public.
The most important borrowers in the capital market are businesses of all sizes that issue long-

term debt instruments representing claims against their future revenues in order to cover the

purchase of equipment and the construction of new facilities. Ranged against these many

borrowers in the capital market are financial institutions such as insurance Companies, mutual

funds, security dealers and pension funds, which supply the bulk of capital market funds.

Open versus Negotiated Markets

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Another distinction between markets in the global financial system that is often useful focuses on
open markets versus negotiated markets. For example, some corporate bonds are sold in the open
market to the highest bidder and are bought and sold any number of times before they mature
and are paid off. In contrast, in the negotiated market for corporate bonds, securities generally
are sold to one or a few buyers under private contract.
An individual who goes to his or her local banker to secure a loan for a new car enters the
negotiated market for auto loans. In the market for corporate stocks, there are the major stock
exchanges, which represent the open market. Operating at the same time, however, is the
negotiated market for stock, in which a corporation may sell its entire stock issue to one or a
handful of buyers.
Primary versus Secondary Markets
The global financial markets may also be divided into primary markets and secondary markets.
Primary Market, also called the new issue market, is the market for issuing new securities. Many
companies, especially small and medium scale, enter the primary market to raise money from the
public to expand their businesses. They sell their securities to the public through an initial public
offering. The securities can be directly bought from the shareholders, which is not the case for
the secondary market. The primary market is a market for new capitals that will be traded over a
longer period.
In the primary market, securities are issued on an exchange basis. The underwriters, that is, the
investment banks, play an important role in this market: they set the initial price range for a
particular share and then supervise the selling of that share. Investors can obtain news of
upcoming shares only on the primary market. The issuing firm collects money, which is then
used to finance its operations or expand business by selling its shares. Before selling a security
on the primary market, the firm must fulfill all the requirements regarding the exchange. After
trading in the primary market the security will then enter the secondary market, where numerous
trades happen every day.
 There are three methods through which securities can be issued on the primary market. These
are:
 Rights issue,
 Initial Public Offer (IPO), and
 Preferential issue.

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A company's new offering is placed on the primary market through an initial public offer. Firms raise new
capital in a primary market transaction by issuing new securities (stocks or bonds) once and
these securities subsequently trade in the secondary market forever.  Initial public offering (IPO)
is stock issued for the very first time to the public when a company "goes public."  The holders
of these stocks can have the following rights:
Preemptive rights - on issuance of additional share allows existing investors to maintain their
ownership position (as a percentage) when new stock is issued.  Without this right investors
would have their ownership interest diluted. 
Rights of offering - allow existing stockholders to buy additional shares in the company at a
subscription price that is generally lower than the market price.
In contrast, the secondary market deals in securities previously issued. Its chief function is to
provide liquidity to security investors-that is, provide an avenue for converting financial
instruments into ready cash. If you sell shares of stock or bonds you have been holding for some
time to a friend or call a broker to place an order for shares currently being traded on the stock
exchanges, you are participating in a secondary-market transaction.
In other words, Secondary Market is the market where, unlike the primary market, an investor
can buy a security directly from another investor in lieu of the issuer. It is also referred as "after
market". The securities initially are issued in the primary market, and then they enter into the
secondary market. All the securities are first created in the primary market and then, they enter
into the secondary market. In other words, secondary market is a place where any type of used
goods is available. In the secondary market shares are move from one investor to other. That is,
one investor buys an asset from another investor instead of an issuing corporation.
Secondary Market has an important role to play behind the developments of an efficient capital
market. The volume of trading in the secondary market is far larger than trading in the primary
market. However, the secondary market does not support new investment. Nevertheless, the
primary and secondary markets are closely intertwined. For example, a rise in security prices in
the secondary market usually leads to a similar rise in prices on primary-market securities, and
vice versa. This happens because some investors will switch from one market to another in
response to differences in price or yield.
Furthermore, it is a market in which stocks once issued are traded –that is bought and sold by
investors. For example it includes the New York stock Exchange (NYSE), National Association

12
of Securities Dealers Automated Quotation (NASDAQ) and American Stock Exchange
(AMEX). 
Secondary market for equity serves two purposes: marketability and Share price valuation:
1. Marketability - allows buyers in the primary market to subsequently sell shares.  It would be
hard to sell stock in primary market if there wasn't a secondary market.
2. Share price valuation - active trading in secondary markets establishes a true fair market value
of stock.
Additional (reading assignment)
Secondary Market further classified as: Dealer Market; Agency Market; Fully Automated
Trading system; and Stock Market Indexes.
A. Dealer Market – OTC (Over the Counter), dealer network, like NASDAQ, where dealers
("market makers") specialize in buying/selling certain stocks. You are buying (selling) the
stock from (to) the dealer, not from (to) another investor, who holds the stock in his/her
account. 
 Bid (dealer buys)
 Ask (dealer sells)
 Spread is the dealer's commission,
For e.g., $5(bid)-$5.05(ask), 1% spread.    
If the market is very competitive; thus the spreads could be very lower.  No limits on the
number of dealers/market makers for a certain stock, and no limit on the number of
stocks a dealer can trade.  
B. Agency Market – Agencies like NYSE are organized as "floor-broker / specialist-market-
maker" centralized trading systems, where face-to-face trading takes place at a physical
location/trading floor.
The broker takes a buy (sell) order from a client/investor/trader, and matches it with a sell
(buy) order from another client/trader. It is more of an auction market.
C. Fully Automated Trading system - It serves in the countries where trading is completely
automated. Quotations and trading takes place directly by computer.  Orders are filled faster,
and very few people are needed to operate an exchange.

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D. Stock Market Indexes-A Stock Market Index is composite value of a group of stocks traded
on secondary markets. Movements in a stock market index provide investors with
information on movements of a broader range of secondary market securities.

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