Interest Rate¶
| Entity | Interpretation of Interest Rat |
|---|---|
| Lender | Income from fixed-income securities |
| Borrower | Cost of borrowing |
| Economist | Base/Rapport rate at which central banks lend to commercial banks |
| Misc | Discount Rate/Compounding Rate/Hurdle Rate |
flowchart LR
Credit --> Borrowing --> Production --> Employment --> Income --> pp[Purchasing Power] --> Demand
Borrowing --> pp
Production -----> Supply
Demand & Supply --> CreditFactors that affect interest Rate¶
- Inflation
- Time
- Risk
Interest-Based Instruments¶
- Simple loan
- Fully amortized loan: Fixed payment loan
- Coupon bond
- Discount bond: Zero-Coupon Bond
YTM¶
Yield Till Maturity
- Coupon
- Capital Gains
- Reinvestment income
Opportunity of
TVM¶
Time Value of Money
Determinants¶
Supply and change in bond market
Change in equilibrium¶
- Change in Price of bond: Movements along a demand/supply curve
- Change due to other factors: Shifts in a demand/supply curve
Shift in Demand¶
| Increase in | Shift in Demand Curve | Bond Price | Interest Rate |
|---|---|---|---|
| Wealth/Purchasing Power | Right | Inc | Dec |
| Expected returns on bonds relative to alternative assets | Right | Inc | Dec |
| Risk of bonds relative to alternative assets | Left | Dec | Inc |
| Liquidity of bonds relative to alternative assets | Right | Inc | Dec |
| Expected Inflation | Left | Dec | Inc |
Shift in Supply¶
| Increase in | Shift in Supply Curve | Bond Price | Interest Rate |
|---|---|---|---|
| Wealth | Left | Inc | Dec |
| Profitability of project for which funds required | Right (Higher cost of capital is tolerated) | Dec | Inc |
| Expected Inflation | Right | Dec | Inc |
| Govt Budget |
Fisher Effect¶
\[ r = i - \pi_e \]
- \(r =\) Real Interest Rate
- \(i=\) Nominal interest rate
- \(\pi_e =\) Expected inflation rate
Structure of Interest¶
| Interest rate of | |
|---|---|
| Risk Structure | Different bonds at same time point |
| Term Structure | Same bond over time |
Risk Structure¶
| Risk Type | Shift in Demand Curve | Bond Price | Interest Rate of Bond | |
|---|---|---|---|---|
| Default Risk | Bond Rating | Left | Dec | Inc |
| Liquidity | Right | Inc | Dec | |
| Income tax exemption | Right | Inc | Dec |
High spread means
Increase in interest rate of bond1 causes a decrease in another bond, due to its change in demand curve