Interest Rates: An Introduction Prof Dr AP Faure Download free books at AP Faure Interest Rates – An Introduction Download free eBooks at bookboon.com Interest Rates – An Introduction 1st edition © 2015 Quoin Institute (Pty) Limited & bookboon.com ISBN 978-87-403-0861-7 Download free eBooks at bookboon.com Interest Rates – An Introduction Contents Contents What are interest rates? 1.1 Learning outcomes 1.2 Introduction 1.3 Financial system: a synopsis 11 1.4 Debt and deposits 13 1.5 The bank margin 16 1.6 Rate of interest 17 1.7 Time value of money 19 1.8 TMV and compound interest 20 1.9 Effective rate 24 1.10 Coupon rate 25 1.11 Price of a security: the principle 26 1.12 Price of a security: multiple future cash flows and yield to maturity 28 1.13 Other issues and terminology related to interest rates 31 1.14 References 37 Fast-track your career Masters in Management Stand out from the crowd Designed for graduates with less than one year of full-time postgraduate work experience, London Business School’s Masters in Management will expand your thinking and provide you with the foundations for a successful career in business The programme is developed in consultation with recruiters to provide you with the key skills that top employers demand Through 11 months of full-time study, you will gain the business knowledge and capabilities to increase your career choices and stand out from the crowd London Business School Regent’s Park London NW1 4SA United Kingdom Tel +44 (0)20 7000 7573 Email mim@london.edu Applications are now open for entry in September 2011 For more information visit www.london.edu/mim/ email mim@london.edu or call +44 (0)20 7000 7573 www.london.edu/mim/ Download free eBooks at bookboon.com Click on the ad to read more Interest Rates – An Introduction Contents Relationship of interest rates 38 2.1 Learning outcomes 38 2.2 Introduction 39 2.3 Relationship between the policy interest rate and the banks’ prime lending rate 39 2.4 The many, but related, interest rates on debt and deposits 40 2.5 Interbank market interest rates 51 2.6 Relationship of money market interest rates 64 2.7 References 65 Composition of interest rates 66 3.1 Learning outcomes 66 3.2 Introduction 67 3.3 67 The yield curve 3.4 Literature on the composition of interest rates 73 3.5 Composition of interest rates: an alternative analysis 75 3.6 Literature on the risk-free rate 77 3.7 The risk-free rate: an alternative view 79 3.8 Relationship of interest rates revisited 79 3.9 References 83 Download free eBooks at bookboon.com Click on the ad to read more Interest Rates – An Introduction Contents Interest rate discovery 85 4.1 Learning outcomes 85 4.2 Introduction 85 4.3 Interest rate discovery and security valuation 85 4.4 Organisational structure of financial markets 86 4.5 Role of secondary markets 97 4.6 Interest rate discovery in the debt and deposit markets 99 4.7 Factors which impact on price discovery 113 4.8 References 114 5 Bank liquidity & interest rate discovery 115 5.1 Learning outcomes 115 5.2 Introduction 115 5.3 Monetary policy models 115 5.4 A bank liquidity analysis 121 5.5 Quantitative easing 124 5.6 Quantitative easing and interest rates 131 5.7 Appendix 1: quantitative easing literature review 133 5.8 References 135 your chance to change the world Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people, business and society Join us In Germany we are especially looking for graduates as Integration Engineers for • Radio Access and IP Networks • IMS and IPTV We are looking forward to getting your application! To apply and for all current job openings please visit our web page: www.ericsson.com/careers Download free eBooks at bookboon.com Click on the ad to read more Interest Rates – An Introduction Contents Role of interest rates 137 6.1 Learning outcomes 137 6.2 Introduction 138 6.3 138 Primary tool of monetary policy 6.4 Part of bridge between present and future consumption 141 6.5 Advancing consumption / investment with debt 144 6.6 Inverse relationship with asset prices and the wealth effect 153 6.7 Interest rates and derivative instrument pricing 163 6.8 166 Interest rates and the foreign sector 6.9 References 166 I joined MITAS because I wanted real responsibili� I joined MITAS because I wanted real responsibili� Real work International Internationa al opportunities �ree wo work or placements �e Graduate Programme for Engineers and Geoscientists Maersk.com/Mitas www.discovermitas.com Ma Month 16 I was a construction Mo supervisor ina const I was the North Sea super advising and the No he helping foremen advis ssolve problems Real work he helping fo International Internationa al opportunities �ree wo work or placements ssolve pr Download free eBooks at bookboon.com �e G for Engine Click on the ad to read more Interest Rates – An Introduction Contents 7 An optimal rate of interest: the natural rate 167 7.1 Learning outcomes 167 7.2 Introduction 167 7.3 The Wicksell hypothesis 169 7.4 Literature review 170 7.5 An alternative interpretation 172 7.6 Reconciliation of PR and PIR / IBMR 174 7.7 Taylor rule 176 7.8 A proposed Taylor-type rule 179 7.9 References 182 Endnotes 184 DTU Summer University – for dedicated international students Application deadlines and programmes: Spend 3-4 weeks this summer at the highest ranked technical university in Scandinavia DTU’s English-taught Summer University is for dedicated international BSc students of engineering or related natural science programmes 31 15 30 March Arctic Technology March & 15 April Chemical/Biochemical Engineering April Telecommunication June Food Entrepreneurship Visit us at www.dtu.dk Download free eBooks at bookboon.com Click on the ad to read more Interest Rates – An Introduction What are interest rates? What are interest rates? 1.1 Learning outcomes After studying this text the learner should be able to: Describe the context of interest rates Elucidate the bank margin and its role Describe what a rate of interest is and related concepts such as per cent, basis points and percentage points Describe the concept “time value of money” Explain compound interest Define coupon rate and the price of a security Differentiate floating rate security and fixed rate security Differentiate primary and secondary market rates Differentiate nominal value and maturity value 10 Differentiate yield rate and discount rate 11 Describe the risk-free rate 12 Elucidate bid and offer rates / prices and spread 13 Distinguish between nominal and real interest rates 1.2 Introduction Before a study of this material is undertaken, it is important to have an understanding of the financial system – which provides the context of interest rates We suggest “Financial System: An Introduction” which is available free at http://bookboon.com/en/financial-system-an-introduction-ebook For those who are familiar with the system, we offer a brief reminder below Interest rates are the reward paid by a borrower (debtor) to a lender (creditor) for the use of money for a period, and they are expressed in percentage terms per annum (pa), for example, 6.525% pa, in order to make them comparable Interest rates are also quite often referred to as the price of money This is not helpful One should rather refer to interest rates as being the rates (there are various) payable on debt and deposit obligations (a.k.a instruments and securities) by the borrowers to the lenders, and that the prices of the debt and deposit obligations are derived from the cash flows payable on the obligations in the future – by discounting the cash flows by the rates payable Download free eBooks at bookboon.com Interest Rates – An Introduction What are interest rates? Upfront we offer a significant statement: short-term interest rates are not determined by supply and demand; they are controlled by the central bank (and there is an especially good reason for this), and all other interest rates are a function of current short-term rates and expectations as to where they will be in the future Supply and demand forces enter the equation – to the extent that the central back reacts to these forces with its administratively-determined interest rate, the policy interest rate (PIR) They play a role in the rate determination on longer term obligations, but the PIR remains the anchor We will return to these issues many times The term interest rate/s can be quite confusing to those unfamiliar with the financial markets There are many different interest rates; a few examples: call deposit rates, term deposit rates, repurchase agreement (repo) rates, base rates, policy rates, bank rates, government bond rates, corporate bond rates, negotiable certificates of deposit (NCD) rates, Treasury bill (TB) rates, corporate / commercial paper (CP) rates, fixed interest rates, floating interest rates, discount rates, coupon rates, real rates, nominal rates, effective rates, risk-free rates, and so on Confusing? Yes, but they are all related and there is a way demystify the terminology This is the aim of this text It also elucidates the significant role of interest rates in the economy We begin with: interest rates apply only to debt and deposit instruments (there are a few exceptions, such as preference shares) To comprehend this, we need to provide a synopsis of the financial system This is provided next The organisation of this text is as follows: • Financial system: a synopsis • Debt and deposits • The bank margin • Rate of interest • Time value of money • TVM and compound interest • Effective rate • Coupon rate • Price of a security: the principle • Price of a security: multiple future cash flows and yield to maturity • Other issues and terminology related to interest rates Download free eBooks at bookboon.com 10