Understanding interest

rates
-------- Bala
 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
 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.
 Opportunity cost
• An example of opportunity cost
• Suppose there are two alternative investment
options available to an investor – investing in
securities @ 12% p.a. return and investing in
land at expected rate of return of 25% p.a.
• In this case if the investor chooses option 1, he
is said to have suffered an opportunity cost of
13% p.a.
• Note: Net opportunity cost = Difference in rates
of return between two alternative investment
options
 Universality of ‘Interest’
• Paid all over to all types of investors in
securities other than equity or preference
share capital
• Equity or preference share capital begets
‘dividend’ that is post-tax
• Islamic law does not permit reward of
interest on investment. Hence
compensation has to be in a different form
in nations that follow Islamic banking
 Interest paid on what?
• Fixed deposit with banks or limited
companies
• Bonds
• Debentures
• Loans
• Overdraft
• Cash credit
 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 of
a country, the less the rate of inflation and vice-
versa
 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?
 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 inflation
in India
 Is that an aberration?
• In a manner of speaking an aberration
• Why so?
• If investors are not attracted to savings in
deposits, then there will be more
consumptive spending
• This will push up the rate of inflation
further
 Constraint on banks increasing
rates on deposits?
• Past low to moderate rates of inflation –
result, ability to give loans at low to
moderate rates
• Constraint on increasing rates of interest
on loans consequent to sudden increase
in inflation; there are legal agreements
between borrowers and banks
• Banks can give only fresh loans at a
higher rate consistent with rate of inflation
Constraint on increasing deposit
rate … 2
• Definite linkage between the average rate
of interest on deposits & average rate of
interest on loans
• Because banks can pay interest to their
depositors only from interest that they earn
on loans
• Constraint on increasing increase rate of
interest on loans, reflected in constraint on
increasing rate of interest on deposits
 Tiered structure for rates of
interest … 2
• Tier 2 = Rate of inflation + some additional
compensation as an incentive
• Tier 3 = Weighted average cost of funds
for 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
 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 depends
upon:
– Sector &
– Expectation of promoters from the sector
• Note: Expectation of promoters from the
sector depends upon their core
competencies, where they lie?
 Summary of 4 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 the
rate of the previous tier
 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%
 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
 Nominal and effective interest
rates
• Nominal rate once again as mentioned in the
deposit receipt, say 10% p.a.; period 36 months
and half yearly compounding
• Effective rate of interest:
• Refer to the formula worked out during the
class
• Effective rate of interest is the average rate per
year after giving the effect of compounding to a
nominal rate
• Note: Effect of compounding depends upon
frequency of compounding
 Fixed and floating rates of
interest
• How does a lender protect against market
fluctuation in rates of interest?
• By offering both on deposits and loans
floating rate option besides conventional
fixed rate option
• What does floating rate mean?
• It means that if market rates go up, the
borrower has to pay higher rate of interest
on his loan
 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 a
lender will gain
 How does one choose fixed or
floating rate?
• A depositor would choose a floating rate in
case in his estimation, the rate of interest
is likely to go up
• Similarly a borrower would choose a
floating rate in case in his estimation, the
rate of interest is likely to come down
• Banks in India adjust the rate in the case
of floating rate arrangement, once in a
quarter
 At a time will fixed and floating
rate differ?
• Yes. The fixed rate will always be higher
by one per cent than the corresponding
floating 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 the
market rate goes up, a new borrower will
get at a higher fixed rate
Switch from fixed to floating and
vice-versa
• Can a borrower switch from floating to
fixed and vice-versa?
• Yes. No problems. Only that the borrower
has to incur one time cost for this switch
 Determination of floating rate of
interest
• For floating rate of interest, there is always a
bench 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
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; in
other 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.
What is the speciality of LIBOR?
• Full form = London Inter-bank offer or
operating rate
• It is universally accepted for all the major
currencies in the world
• Rate keeps on changing every day
• Rate depends upon:
– Currency for lending &
– Duration of lending
 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
 Money market instruments –
Interest on them
• All money market instruments – interest is
included in the maturity value
• Suppose one treasury bill is for Rs. 1
crore, this value includes interest payable
for the period
• What does it mean?
• This means that Rs.1 crore, as reduced by
interest payable in future is collected at the
time of investment
 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