UNIT-TWO

DETERMINANTS OF
INTEREST RATE

BBA 7th Semester, TU

Everest College, Thapathali, Kathmandu
Yagya Raj Bhandari
Concept of Interest Rate

The concept of interest rate tells us how interest rate determined and why level
of interest rate goes up and down time to time.

The interest rate is associated with bonds, debentures, deposits, loans etc. The
interest rate is also popular as cost of money. It is cost for one party but return to
the another party. The interest rate also can be define as compensation period for
money used. Interest rate generally depends upon demand and supply of money.
Interest rate also depend upon risk of the investment.
Contd…….

It means of the level risky is higher interest rate also becomes higher and vice
versa.
1) Nominal interest rate:
Nominal interest rate is total interest earned during the year. it is also known
as simple interest rate or annual interest rate. Interest rate on deposit, interest
rate on loan, interest rate on bond etc. are nominal interest rates. The nominal
interest rate is calculated as follows:
Contd……

• Nominal rate on Treasury bill (r) = K* + IP

• Nominal rate on Treasury bond (r) = K* + IP + MRP
• Nominal rate on Corporate bond (r) = K* + IP + MRP + LRP + DRP
Where;
K* = Real risk free rate or minimum return without adjusting any risk factors.
IP = Inflation premium (Average of inflation rates)
DRP = Default risk premium
MRP = Maturity risk premium
LRP = Liquidity risk premium
Contd……
•  
Calculation of inflation premium:

 Inflation premium for one year bond (IP1) = I1

 Inflation premium for two year bond (IP2) =

 Inflation premium for three year bond (IP3) =

Contd…….

 Real risk free rate:

Real risk free rate is minimum return on government securities without adjusting
any risk factors. In other word it is pure return earned on government securities.
 Inflation premium:
The inflation is increase in price level of the goods and services which is a kind of
risk to the people. To compensate this risk investors requires certain additional
return from investment which is called inflation premium.
Contd……

 Maturity risk premium:

If we make investment for the long period it can be risky due to fluctuation in price of
security. To compensate this risk investors requires certain additional return from
investment which is known as maturity risk premium.
 Default risk premium:
Default risk premium is chance of being bad debt our investment. To compensate this
risk investors requires certain additional return from investment which is known as
default risk premium. Corporate bonds have chance of default risk.
Contd………

 Liquidity risk premium:

Liquidity risk premium is difficult to converting investment into the cash. To compensate this
risk investor requires certain additional return from investment which is known as liquidity risk
premium.

2) Real rate of return:

Real rate of return is actual return earn by the investor after adjusting inflation rate. In other
word it is difference between nominal interest rate and inflation interest. Real rate of return
shows actual increase in wealth position or increase in purchasing power from the investment.
Contd……
•Real
  rate of return (rr) =
3) Effective annual rate:
Effective annual rate is total compounded interest earned during the year.
Effective annual rate =
r = nominal rate
M= no of compounding period
=360/maturity period
Contd……..

4) Spot interest rate:

Spot interest rate is today’s interest rate of the bond. The YTM of zero coupon
bond is also called spot rate. Commonly spot interest rate is calculated using
forward interest rate.
- Spot interest rate on 1 year bond (0S1) = 0F1
- Spot interest rate on 2 year bond (0S2) = [(1+0F1) (1+1F2)]1/2 -1
- Spot interest rate on 3 year bond (0S3) = [(1+0F1) (1+1F2) (1+2F3)]1/3 -1
Contd……..
•  
5) Forward interest rate:
Forward interest rate is expected future interest rate of the bond. Forward
interest rate is calculated using spot rates.
- Forward rate from year 1to2 (1F2) = - 1
- Forward rate from year 2to3 (2F3) = -1
- Forward rate from year 2to4 (2F4) = - 1
Term structure of interest and yield curve

The term structure of interest rate shows relationship between maturity period and interest
rate. Commonly there is positive relationship between maturity period and interest rate it
means longer the maturity period higher will be interest rate and vice versa. Further more the
relationship between maturity period and interest rate can be explained as follows.
1)Increasing term structure:
If interest rate increases according to increase in maturity period it is called increasing term
structure. In such situation the interest rate curve will be upward sloping.
Contd…….

2) Decreasing term structure:

If interest rate decreases in increasing maturity period it is called decreasing term structure

of interest rate. In such situation the yield curve will be downward sloping.

3) Flat term structure:

If interest rate remains unchanged even increase in maturity period it is called flat term

structure. In such condition the interest rate curve will be flat sloping.
Theories about term structure of interest rate

As we know, the term structure of interest rate is relationship between maturity periods an
interest rate. The interest rate theories explain about why interest rate goes ups and down.
The main theories are as follows:
1) Expectation theory:
According to this theory the level of interest rate mainly depends upon expected future
inflation rates. It means if future inflation are expected to be increasing the rate of
interest will also higher and vice versa. Furthermore, this theory also tells us that, long
term interest rate is average of short term interest rates.
Contd……

2) Liquidity preference theory:

According to this theory the level of interest rate depends upon liquidity preference
of the investors. This theory tells us that, investor requires extra return on long term
bonds due to their lower liquidity which is known as liquidity premium.
-Liquidity premium for 1 year bond: (LP1) = 0
-Liquidity premium for 2 year bond: (1+0S2)2 = (1+0F1) (1+1F2+ LP2)
-Liquidity premium for 3 year bond:(1+0S3)3 = (1+0F1) (1+1F2+ LP2) (1+2F3+ LP3)
Contd……

3) Market segmentation theory:

According this theory the interest rate for short period and long period determined separately by the demand
and supply according to maturity preferences of the fund within the financial market. For example when supply
of short term fund is higher then interest rate on short term fund is lower than long term funds.

4) Loanable fund theory:

According to this theory interest rate is determined by the demand and supply of loanable fund or credit fund in
the financial market. The demand and supply of loanable fund is created by house hold sector, business sector
and government units in financial market. The equilibrium interest rate is determined at that point where
demand of loanable fund and supply of loanable fund are equal.