INTEREST RATES AND THEIR ROLE IN

FINANCE
FINANCE 7 PART 5
 CONCEPT OF INTEREST RATES

 Interest rate denotes percentage earnings or yield on investment. It is the cost of using
money expressed as a percentage of the principal for a given period of time, which is
usually per year. It is generally regarded as the cost of borrowing or lending out of
money or the cost of credit. It plays an important role in finance, such as demand for
money and the velocity of money. Interest rate fluctuates and affects market prices of
securities in the financial markets and the prices of goods and services. It is therefore
an important consideration for decision makers. How attractive interest rates are will
show how investors will react to them. The higher the interest rate, the better it would
be for investors, but is undesirable for borrowers for they have to pay a higher cost for
their borrowings.
 DEMAND FOR AND VELOCITY OF MONEY
SPECIFICALLY, NOMINAL INTEREST RATE, THE MONETARY RETURN ON SAVING, IS DETERMINED BY THE SUPPLY
AND DEMAND OF MONEY IN AN ECONOMY. THE AMOUNT OF MONEY THAT PEOPLE DESIRE TO HOLD AS A STORE OF
VALUE IS THE DEMAND FOR MONEY. IT IS HOW MUCH MONEY PEOPLE AND THE FIRMS DECIDE TO HOLD IN THEIR
WALLETS OR COFFERS. THE DEMAND FOR MONEY IS A FINANCIAL DECISION, THAT IS, HOW MUCH OF MY WEALTH
SHOULD I HOLD IN THE FORM OF MONEY? THE PRIMARY BENEFIT OF HOLDING MONEY IS THAT IT IS THE MOST LIQUID
OF ALL ASSETS. SO, THE DEMAND FOR MONEY IS THE DEMAND FOR LIQUIDITY. AS IT TURNS OUT, THE PRICE OF
MONEY IS THE OPPORTUNITY COST OF HOLDING MONEY. SINCE CASH DOES NOT EARN INTEREST, PEOPLE GIVE UP THE
INTEREST THAT THEY WOULD HAVE EARNED ON NON-CASH SAVING WHEN THEY CHOOSE TO KEEP THEIR WEALTH IN CASH INSTEAD.
THEREFORE, THE OPPORTUNITY COST OF MONEY AND AS A RESULT, THE PRICE OF MONEY IS THE NOMINAL INTEREST RATE.
PEOPLE HAVE DIFFERENT REASONS FOR HOLDING ON TO MONEY OR THEIR DEMAND FOR MONEY. AS SUCH, WE HAVE
THE FOLLOWING TYPES OF DEMAND ACCORDING TO LAMAN (2003):
1. TRANSACTION DEMAND. SINCE PAYMENT FOR EXPECTED EXPENDITURES LIKE PURCHASE OF GOODS, PAYMENTS
FOR ELECTRICITY BILL, WATER BILL, TELEPHONE BILL, TUITION FEE AND OTHERS, DOES NOT COINCIDE WITH THE
RECEIPT OF INCOME, PEOPLE TEND TO HOLD ON TO MONEY TO PAY FOR ALL THOSE EXPENSES.
2. PRECAUTIONARY DEMAND. OTHERS HOLD ON TO MONEY IN PREPARATION FOR UNFORESEEN ADDITIONAL
EXPENSES CAUSED BY UNEXPECTED EVENTS LIKE SICKNESS, INJURY FROM ACCIDENT, OR LOSS OF PROPERTY.
3. SPECULATIVE DEMAND. BUSINESSMEN AND INVESTORS, HOLD ON TO MONEY WITH THE INTENTION OF USING IT
WHEN AN OPPORTUNITY TO EARN MORE ARISES.
INTEREST RATE, PRICES, DEMAND FOR MONEY, AND VELOCITY OF MONEY

What causes the demand for money to rise or fall? Basically, interest rates and prices are
among the factors that cause the demand for money to rise or fall. Whatever reasons
people have for holding on to money, they may change when the interest rate changes. As
the real rate of interest rises, the opportunity cost of holding money rises. As the cost of
holding money rises, people will desire to hold less money; therefore, as interest rate rises,
demand for money falls. This is because, in addition to the rising opportunity cost of
holding money, people tend to restrict borrowings because they know it will cost them
more. Similarly, those who have money will not hold on to it because it will not earn them
anything. Rather than holding on to their money, people will invest or place their money
in interest-bearing assets, like in the money market or securities, to earn more. High
interest rates will benefit the investors more than the borrowers.
 TYPES OF INTEREST
 1. NOMINAL INTEREST RATE

The opportunity cost of money, and as a result, the price of money is the nominal interest rate.
Conceptually, nominal interest rate is the simplest type of interest rate. It is the stated interest rate of a given bond or
loan. This type of interest rate is referred to as the coupon rate for bonds and other fixed-income investments or
loans granted by financial institutions. The nominal interest rate is, in essence, the actual monetary price that
borrowers pay to lenders to use their money.
2. REAL INTEREST RATE
Real interest rate is so named because it states the “real” rate that the lender or investor receives or a
borrower pays after considering inflation. Real interest rate is the interest rate that is adjusted for expected changes
in the price level to accurately reflect the true cost of borrowings.
3. FIXED INTEREST RATE
A fixed interest rate means that the interest rate that you will be charged over the term of your loan will not
change, no matter how high or how low the market may drive interest rates. You payment will remain the same on
your last payment as it was on your first payment.
 TYPES OF INTEREST

4. VARIABLE INTEREST RATE

Also called floating rate, a variable interest rate means that the interest you are charged changes as whatever
index your loan is based on changes. Loans can be based on the rate of the 1-year T-bill or the prime lending rate among
other factors. Variable rates consist of two components: An index, plus a credit-based margin determined by the
lender. The starting rate on a variable rate loan is usually lower than the rate on a fixed rate loan. The index rate will
vary over time based on economic conditions.

DIFFERENCE BETWEEN INTEREST RATES AND RATES OF RETURN

The interest rate is the measurement of interest income, yields, dividend, income, or profit directly derived from the
investment. The capital gain is the increase in value. Rates or Return (ROR) is generally applied to financial assets.
 INTEREST RATES AND THEIR ROLE IN FINANCE

Finance deals with funds, and funds generally denote money. The earnings on money lent and the cost of money
borrowed are expressed as a percentage of the principal amount of money lent or borrowed called interest rate. Since
finance is a major concern of monetary policy, we have also seen that the BSP uses interest rate as the primary
instrument of monetary control. Remember that the official interest rate is the reverse repo rate (RRP) or the overnight
borrowing rate, which is the borrowing rate on the reserve requirement for banks set by the BSP.
Changes in interest rates have implications for a multitude of phenomena in the business and economic world. The
level of investment spending, level of consumer expenditures, redistribution of wealth between borrowers and lenders,
and prices of financial securities are among the ones affected by any change in the interest rate. They either go with the
direction of the interest rate or go against it, that is, they can have a direct relationship or an inverse relationship.
Central banks use interest rates to control money supply, demand for money, reserve requirements, and other
monetary tools to maintain a healthy and stable economy. The multitude of yields at any given time is accounted for by
differences in default risk, tax considerations, marketability and liquidity, maturity period, and the like. Interest rates on
government securities, because they are most default-free, are usually used as benchmark yields for all other securities.
 INTEREST RATES AND THE ECONOMY
Interest rates have the following important roles in the economy:
1. Ensure that current savings will flow into investment to promote economic growth.
2. Ration the available supply of credit to provide loanable funds to those investment
projects with the highest expected returns.
3. Bring into balance the supply of money with the public’s demand for money.
4. Act as an important government tools through its influence on the volume of savings
and investment. If the economy is growing too slowly and unemployment is rising, the
government can use it policy tools to lower interest rates in order to stimulate
borrowing and investment which will eventually encourage production and create
employment. On the other hand, an overheated economy experiencing rapid inflation
calls for a government policy of higher interest rates to slow both borrowing and
spending.
 INTEREST RATE THEORIES
There exists theories concerning the determinants of the pure or risk-free interest rate. These theories are:
1. Classical theory/Fisher hypothesis
2. Loanable funds theory
3. Liquidity preference theory
4. Rational expectations theory
CLASSICAL THEORY
This is one of the oldest theories concerning the determination of the pure of risk-free interest rate developed during the eighteenth and
nineteenth centuries by a number of British economists, refined by Austrian economist Bohm-Bawerk, and elaborated by Irving Fisher early in
the twentieth century. This theory posits that the rate of interest is determined by two factors:
5. Supply of savings
6. Demand for investment capital
This theory highlights the importance of households and businesses. Saving are generally carried on by individuals and families
(households) and for these households, they are simply abstinence from consumption spending. Consumption spending means spending for
both durable and non-durable goods and services. Thus, savings are equal to income minus consumption expenditures. Decisions on the
timing and amount of savings are affected by several factors. These include the size of current and long-term income, the desired savings
target, and the propensity to save. The higher the income, the higher the savings. Households having more income tend to save more as
compared with those with lower incomes.
 LOANABLE FUNDS THEORY
Loanable funds theory is often used for forecasting interest rates. This theory is based on the premise that the interest rate is
the price paid for the right to borrow or use loanable funds. Therefore, borrowers create the demand for loanable funds and
the lenders, on the other side of the market, seek to provide the loanable funds needed by the borrowers. Households,
businesses, and governments participate in both sides of the market. They are all both borrowers and lenders at one time or
another.
Households invest whatever savings they have from their incomes. They also borrow when their incomes are insufficient to
support their needs, especially for unforeseen events such as death or calamities. They borrow for housing needs, educational
needs, funeral needs, hospital needs, and the like. They also deposit money in the bank and invest in other financial
instrument that they can afford.
Businesses are active participants in the financial markets borrowing from the market for inventories; working capital needs;
purchase of property, plant, and equipment; and other projects by issuing stocks and bonds. They also act as surplus units
when they purchase securities from the financial markets.
Governments borrow from the financial markets by issuing government securities like T-bills, T-notes, and T-bonds when they
have deficits. But the government also buys financial securities from the financial markets whenever they have surplus funds.
Foreign lenders and foreign borrowers also exist. IMF is a great provider of loanable funds. Foreign businesses buy and
engage in the financial markets, too.
 LIQUIDITY PREFERENCE THEORY
In 1930, John Maynard Keynes introduced the concept of money demand and used the term “liquidity preference” for
money demand. This is the reason this theory is called liquidity preference theory. This theory stipulates that the interest
rate is determined in the money market by the money demand and the money supply. Interest rate is the point where the
money demand is equal to money supply.
The liquidity preference theory gives insights on how an investor behaves and how the government uses interest rate as a
monetary tool. Investors purchase securities when interest rates are high for the simple reason of yield, increasing the
supply of funds in the financial system. They shy away from buying securities when interest rates are low, thereby
reducing the supply of money in the financial system. Similarly, the government can regulate the money supply ensuring
that it grows slowly than money demand to bring about higher interest rates. Contracting money supply when there is
plenty of it in the financial system ensures higher interest rates. In contrast, if the government expands money supply
when there is low supply, interest rates go down.
Like the other theories, this theory also has its limitations. It is a short-term approach to interest rate determination,
modified because it assumes that income remains stable. In the longer term, interest rates are affected by changes in the
level of income and inflationary expectations. It considers only the supply and demand for the stock of money, whereas
business, consumer, and government demands for credit clearly have an impact on the cost of credit. There is a need for a
more comprehensive theory giving consideration to the roles of all participants in the financial system.
 RATIONAL EXPECTATIONS THEORY

Rational Expectations Theory came about in the advent of the Information Age. It is based
on the premise that the financial markets are highly efficient institutions in digesting new
information affecting interest rates and security prices. When new information appears
about investment, saving, or money supply, investors immediately translate this
information into investment or borrowing decisions.
In the rational expectations world, people are assumed to behave as if they were tuned into
the state-of-the-art moadel of inflation. Thus, as new information on key determinants of
inflation becomes available, they quickly plus it into their inflation model and revise their
outlook accordingly.
 DETERMINANTS OF INTEREST RATES
There are various factors in the economy-inflation expectations, the government’s monetary policy, the business cycles,
government budget deficits, savings, investment demand, money supply growth, demand for cash balances-that determine
interest rates. The supply of or demand for loanable funds trigger changes in interest rates. Among the major determinants of
interest rates are:
1. Inflation expectations
2. Monetary policy
3. Business cyle
4. Government budget deficits
The level of interest rates strongly tends to rise in periods in which the expected rate of inflation increases. Interest rates
usually fall when expected inflation goes down. The government monetary policy, like measures to encourage loan-granting
by banks and other financial institutions by decreasing interest rates, it designed to encourage borrowing. Similarly, to restrain
economic activity, interest rates are increased to discourage borrowings, which could have caused an increase in production.
As such, interest rates follow the business cycle. Theoretically, a nation’s budget deficit should raise interest rates with an
increase in borrowing by the government to fund the deficit. Larger budget deficits are expected to raise inflation expectations
pulling interest rates up via the Fisher effect.
 MEASUREMENT OF INTEREST RATE
1. SIMPLE INTEREST RATE
From the viewpoint of the saver, the interest rate is the percentage of interest income received over the money lent for a
period of time, and from the viewpoint of the user, the interest rate is the percentage of interest expense paid over the money
borrowed for a period of time. This is the measurement of simple interest rate.
Examples: from the viewpoint of the saver
Mr A placed his P1,000,000 in a special deposit account with Bank X for 1 year. At the end of the year, he received
P1,100,000. The interest rate from the transaction is 10% computed as follows:
Interest Rate = Interest Income /Principal
= (P1,100,000-P1,000,000)/P1,000,0000 = P100,000/P1,000,000 = 10%
From the viewpoint of the user:
Mr. B needed P1,000,000 for additional funding of his business. Bank X lent him the required fund for 1 year. At the end of
the year, Mr. B paid Bank X the amount of P1,200,000. The interest rate from the transaction is 20% computed as follows:
Interest Rate = Interest Expense/principal
= (P1,200,000-P1,000,000)/P1,000,000 = P200,000 /P1,000,000 = 20%
 COMPOUND INTEREST RATE

Compounding involves giving interest to interest earned, that is, the interest earned in the
first period is added to the principal. The result becomes the principal for the second
period, thereby earning a higher interest in the second period. For example, if a bond pays
6% on an annual basis and compounds semi-annually, then the investor who invests
P1,000 in this bond will receive P30 of interest after the first 6 months (P1,000 x .03) and
P30.90 of interest after the next 6 months (P1,030 x .03) The investor received a total of
P60.90 for the year, which means that while the nominal rate was 6%, the compound rate
was 6.09% (P60.90/P1,000). The difference between the nominal and effective rates
mathematically increases with the number of compounding periods within a specific time
period.
 EFFECTIVE INTEREST RATE (EIR)

Effective interest rate is measured based on the kind of credit and its term, particularly on short-term credit,
which includes:
a. Trade credit. It is a spontaneous credit from regular purchase of goods. Some suppliers provide credit
terms and cash discounts for early payment such as 2/10, n/30. The discount rate is 2% which means that
2% of the invoice price is deducted once paid within the discount period.
b. Bank Loans in the form of line of credit are lending arrangement between a bank and a borrower, in
which the bank provides the borrower a maximum amount of funds during a specified period of time.
Normally, the bank requires the borrower to maintain a minimum cash balance in the bank called
compensating balance throughout the term of the loan. It could also be a discounted loan in which the
interest is paid in advance.
c. Bank Loan in the form of transaction loan. This is an unsecured short-term bank credit made for a
specific purpose. It could be a discounted loan with compensating balance requirements or regular loan
in which the interest is paid at the maturity period.
YIELD TO MATURITY

Yield to maturity is the interest rate which equates the present value of all cash flow from debt instrument
with the current value; hence, the net present value or NPV is equal to zero. It is also known as the
internal rate of return (IRR). There are different ways to measure yield to maturity depending on the type
of instrument.
a. For simple loan, YM = simple interest rate
b. For coupon bond in which interest is paid annually and the principal is paid at maturity period, the
estimated yield to maturity (EYM) and the interpolation can be used in determining the actual yield to
maturity.
c. Current yield (CY) is the yearly coupon payment ( C ) divided by the price of the security ( P).
d. Yield at a discount basis (DY).