5 Ocak 2013 Cumartesi

What is Interest? What are the Main Factors Affecting Interest rates?

Interest is a very famous economic concept which takes part in all financial or economic decisions. It is being followed by the companies, individuals and also by the governments. After the globalization occurred in the late 1960’s, the interest rate that had been decided by the governments or by the markets, affected the interest and currency prices in the other countries.

In this study we will be dealing with interest concept and we will go into detail to the types of the interest and other classification styles. After defining the concept, Turkish market will be analyzed according to the interest types.

What is Interest?

Interest is generally known as the cost of borrowing or the price paid for the rental of funds.[1] Interest rates are also major tools of monetary policy and are used to control variables like investment, inflation, and unemployment.[2]

This variable is an important parameter because it affects personal decisions. High interest rates could deter you from buying a house or a car because the cost of financing would be high. On the other hand they could encourage people to save more. The people can earn substantial income by putting savings into an account at the bank when interest rates are high.

On the other hand, the following groups of people follow current interest rates:[3]
·   Savers
·   Borrowers
·   Policy makers
·   Forecasters

Interest rates cause some major effects in the life of the people. These are stated below:[4]
·   Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory, people prefer goods now to goods later, in a free market there will be a positive interest rate.
·   Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.
·   Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.
·   Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
·   Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.
Interest rate can be classified into two categories regarding the calculation style. These two styles are shown in the following:
·   Simple interest
·   Compounded interest
 Simple interest is that part of the interest rate that remains after removing those parts that represent compensation for the risk of giving a loan and for the expected inflation rate.[5] Simple interest can also be summarized as not applying interest on the past interest income. Interest gain is paid after the maturity of the investment tool. The calculation formula is given below:[6]

Total Interest Gain = i x n                                                              (1)
i= interest rate
n=tenor (maturity of the tool)

Second and commonly used interest rate is the compounded interest rate. This also known as the effective rate in which the investors gain interest income from past interest income.[7] The calculation of this interest rate is shown below:

Compounded Interest = (1+i) n -1                                                  (2)
i= interest rate
n=tenor (maturity of the tool)

Further, there are two more interest rates called nominal interest and real interest. Nominal interest is the simple interest charged for a period of time. On the other hand, real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero. Further we know that there is a positive correlation between interest rates and inflation.[8]

Therefore, the real interest rate is calculated according to the below formula.[9]
ir = (1+in) — (1+p)                                                                                         (3)
p = the actual inflation rate over the year.
in = nominal interest rate
ir = real interest rate

[1] Frederic S. Mishkin, The Economics Of Money, Banking And Financial Markets, (USA:Little and Brown,1986), 7.
[2] Wikipedia, “Interest Rate,”
< http://en.wikipedia.org/wiki/Interest_rate>
[3] D.Foster, “Interest Rates,”
[4] Wikipedia, “Causes of Interest Rate,”
< http://en.wikipedia.org/wiki/Interest_rate#Causes_of_interest_rates>
[5] Joseph Hasslberger, “Interest Suffocating The World,”
< http://www.hasslberger.com/economy/eco_2.htm>
[6] Richard A.Brealey, İşletme Finansının Temelleri, (İstanbul:Literatür, 1997), 54.
[7] Brealey, 54.
[8] Cameron, “Inflation, Yield Curves and Duration,”
[9] Wikipedia, “Real vs Nominal Interest Rates,”
< http://en.wikipedia.org/wiki/Interest_rate >

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