INTEREST RATE STRUCTURE

FUNCTIONS OF INTEREST
Capital is essential in the field of production. Interest is to be paid for utilisation of capital in any type of
financial system. For this functions of interest are important. Functions of interest are discussed below:

(1) Increase of Production: It is not possible for all institutions to continue production activity with its own
capital alone. For this purpose, capital may be borrowed from outsiders. Production increases with the
help of this capital. Though the owner of the capital gets a portion of enhanced production as interest.
(2) Control of Allocation of Capital: Interest distributes insufficient capital in three utility areas –
production, consumption and desire for preserving money. The entrepreneurs will pay higher interest
rate in the areas where more production will be, if capital is invested. Then supply of capital will be
more and production will increase.
(3) Creation of Savings: Savings is the excess of income over consumption and investment amount. The
income available from the investment of money with different organisations is considered as interest.
People will not be encouraged in savings without interest. Consequently supply of savings will reduce,
production investment and income will reduce in the country. So, interest is reward of the savers only.

INTEREST RATE
The rate of providing money by lender for the utilisation of capital is called interest rate. Hence interest rate
suggests per cent of annual interest rate. But there is no fixed rule that interest rate will be annual. Interest
rate may be weekly, monthly and half yearly. Therefore interest rate depends on the period of time.
Gross interest = Interest rate × Amount of Capital.
If Rs. 500 is borrowed at the rate of 10% p.a., then gross interest will be at the end of the year 10÷100 × Rs.
500 = Rs. 50. If the amount ‘P’ as loan is borrowed at the rate of r%, then gross amount at the end of the year
will be Rs. P × r÷100. So the concept of interest rate and gross interest are different.
Interest rates and forecasts of their future values are among the most important inputs into an investment
decision. One can exercise option to invest his money in different types of securities either long-term or in a
savings bank also. So decision depends critically on his outlook for interest rates.

GROSS INTEREST RATE AND NET INTEREST RATE

Conceptually interest can be of two types – gross interest and net interest.
1. Gross Interest Rate: The rate amount of money, borrower paid to the owner of capital or the lender at
the end of certain period is called gross interest rate.
2. Net Interest Rate: On the other side, there are always risks in disbursement of loan. If there is no
apprehension of getting back money in time the lender may demand a little more interest. Besides
labour and money might be spent for realisation of loan amount. For all these risks and uncertainties
the owner of capital may claim more interest. Net interest is available after deduction of expenses for
risk, uncertainty and realisation of loan amount from gross interest. Therefore, net interest rate is the
price for utilisation of capital.

ELEMENTS OF GROSS INTEREST RATE

1. Pure Interest: Price for the utilisation of capital is called interest. The price the borrowers have to pay
for the loan amount of the lender is pure interest. It exists in gross interest.
2. Risk: Both risk and uncertainty exists when loan is distributed. Whether return will be available returns
doubtful. Therefore interest at higher rate is claimed that it should be for utilisation of capital only. The
risk may be of two types –
 (i) Personal risks due to unreliable character of the borrower himself, and
(ii) Trade risks.
Interest rate increases due to business risk. Whether income will be available perfectly, it has no
guarantee.
3. Wages of Management: Money lending always continues in business. Management is required for
transactions of money lending. The lending has to keep accounts and arranges for new loans for short-
term period. As a result expenses of these activities are included in interest and interest rate increases.
4. Return for Inconvenience: The lender may face inconveniences from different corners. The lender has
no control over the money once lent. Even in time of his own need, he may not get back money. As a
result he has to fulfil requirements by lending from others. The lender may claim compensation for this
inconvenience. Interest rate is higher in the areas where such inconveniences are more. Again interest
rate is lower in places where inconveniences are less.

DIFFERENCE BETWEEN GROSS INTEREST AND NET INTEREST RATES

Subject Gross Interest Rate Net Interest Rate
1. Definition The rate of interest the borrower pays to Net interest rate is the rate amount of
lender at the end of a certain period is money paid for utilisation of loan only.
called gross interest rate.
2. Rate Gross interest rate is higher than net Net interest rate is less than gross interest.
interest.
3. Part Net interest is a part of gross interest. Net interest includes in the gross interest.
4. Elements Important elements like risk, wages of These elements are not related with net
management and inconvenience for return interest, this is only price for utilisation of
included in gross interest. capital.

REAL INTEREST RATE AND NOMINAL INTEREST RATE

Nominal Interest Rate: The nominal rate refers to the rate of interest before adjustment for inflation. The
nominal interest rate actually we mean real interest rate plus the expected rate of inflation. In other words,
nominal interest rate may be defined as the growth rate of your investment.
Nominal Interest Rate = Rate Interest Rate + Expected Inflation Rate
Suppose the real interest rate is 5% p.a. and the expected inflation rate is 7%. Then the nominal rate of
interest is 12%. It expected inflation rises then purchasing power will decrease.

Real Interest Rate: Real interest rate is the rate of interest an investor expects to receive offer allowing for
inflation. The factors that determine real interest are supply of funds from savers, the demand for funds from
businesses to be used to finance investments in plant, equipment and inventories and the government’s net
supply of or demand for funds as modified by action of the central bank.
Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate
If the inflation turns out higher then real interest rate will be lower and the inflation rate is lower then real
rate will be higher. Again if inflation rate is higher than the interest rate then real interest rate will be
negative.

COMPONENTS OF NOMINAL INTEREST RATE

At the time of determination of nominal interest rate certain factors or elements have been considered. These
are:
(1) Real Interest: The key element of nominal interest is the real interest. For using of real capital, interest
is being paid to the owner of capital is called real interest. Risk and uncertainty, transaction costs are
included in the real interest. If risks and transaction costs get reduced then the rate of interest will also
be reduced. At the same time nominal interest rate will decrease accordingly.
 (2) Expected Inflation: Inflation is another important element for determination of nominal interest. If
inflation increases in a country, whereas income level remains constant at the same time, then
purchasing power will decrease.

DIFFERENCE BETWEEN NOMINAL INTEREST RATE AND REAL INTEREST RATE

Subject Nominal Interest Rate Real Interest Rate
1. Definition The nominal interest refers to the rate of Real interest is the rate of interest an
interest before adjustment. investor expects to receive after allowing
for inflation.
2. Rate Nominal Interest rate is higher than the real Real interest rate is lower than the
interest rate. nominal interest rate.
3. Determinant The determinants of nominal interest rate The determinants of real interest rate are
are supply demand government actions and supply, demand and government actions.
expected inflation.
4. Negative It cannot be negative. If the rate of interest is higher than the
inflation rate then it will be negative.
5. Measurement Nominal interest rate measures the growth Real interest rate measures the growth
rate of money. rate of purchasing power.

DIFFERENTIAL INTEREST RATE

Different kinds of interest are found in financial markets. Different interest rates may be on different types of
loans. Borrowers used to pay different rates of interests as monopolistic competition exists in financial
markets, though much difference is not found in pure interest rate for the same time in financial markets. Risk
has close relationship with interest rate, this rate depends on degree of risk for different kinds of interest.
Except this interest rates may change for different inconveniences of the lenders.
Different types of interest rates have been found in government and private organisations for control over
money market, nature, risk and easy availability of capital. In India, RBI and Central Government of India
control money market mainly. For this, interest rate particularly in government institutions administered rate
is found. As this control is less in private sector, interest rate is controlled by market. Difference of interest
rate can be divided into three sections –
(1) Administered interest rate,
(2) Market determined interest rate, and
(3) Interest rate on the basis of period of time.

DIFFERENCES BETWEEN ADMINISTERED INTEREST RATE AND MARKET DETERMINED INTEREST RATE
Subject Administered Interest Rate Market Determined Interest Rate
1. Definition This interest rate determined by individual In a financial system, the interest rate
organisations or lenders themselves in determined by demand and supply of
called administered interest rate. money and interaction of other forces is
called market determined interest rate.
2. Stability of Administered interest rate does not Interest rate change due to changes of
Rate change. Therefore this interest can be demand and supply of money. For this its
changed by respective organisation only. stability is shorter.
For this its stability is longer.
3. Classification Administered interest rate may be Market determined interest can be
classified into two categories – (i) interest classified into two categories – (i) interest
rate on savings, and (ii) interest rate on rate on long-term government loan, and
term loan. (ii) interest rate on other market debts.
4. Determination Lender institutions itself determines Here interest rate is not determined by
interest rate or interest rate is determined any certain institution. It is determined by
by any other institutions. As in India, RBI supply and demand of loan.
 determines interest rates on different
types of deposits.
5. Control Such interest rate is called controlled Such interest rate is called deregulated
interest rate. interest rate.

RELATIONSHIP BETWEEN SHORT-TERM AND LONG-TERM INTEREST RATES

The determination of interest rates depends on various factors such as liquidity, default risk, time of maturity
etc. Investors or lenders think about the liquidity of their investments or assets. Long-term investments
cannot be liquidated easily. So long-term assets or loan are more risky than short-term securities and assets.
Investors or lenders charge higher interest on long-term securities because of inflation.
From the viewpoint of default risk, the term structure of interest rates on the homogenous assets is such that
short-term rates are higher than the long-term rates. The more the risky the security, the higher the interest
rate has to offer.
In case of expectation theory, if an investor expects future short-term spot rates to be higher than the current
short-term spot rate then long-term rate will be higher than the short-term rate.
Again when investors expect future short-term spot rates to fall below the current short-term spot rate then
long-term rate will be lower than short-term rate.
In India short-term interest rates on bank deposits are lower than the long-term bank deposits interest rate.
At the same time yield on short-term government securities is lower than the medium-term yield.

RELATIONSHIP BETWEEN INTEREST RATE AND ECONOMIC PROGRESS

Interest in the price paid for borrowed funds. Since interest rate is the cost to the borrower and return to the
lender, it affects the margin among other things, borrowing and lending, investment and saving, portfolio
composition, selection of projects and their lives, capital-intensity of production techniques chosen.
There is a close relationship between economic growth and capital formation. Capital formation is an essential
determinant of economic growth. It is quite necessary to determine the desirable rate of capital formation.
The process of capital formation can take place by an increase in the volume of real domestic savings so that
the resources that would have been used for consumption are released for investment.
One of the macroeconomic policy in India is to increase the rate of savings. National self- sufficiency in savings
is required for reducing the economic and political costs of capital formation and for minimising instability,
volatility, contagion, vulnerability and crises. Low interest rates are economically and socially undesirable in a
capital scarce country like India. This will act as a disincentive to save.
Low interest rates in theory are supposed to encourage investment, help fight recession, revive the economy
and accelerate the rate of economic growth. But in practice, such a negative relationship between economic
progress and interest rate has rarely been found to exist in India.
The low interest rates policy will distort the structure of rates of return on various financial and real assets.
This type of interest policy has discriminated against bank deposits, small savings, provident funds, other debt
instruments and so on.
Some economists and monetary authorities themselves have argued for the gradual reduction in interest
rates and the withdrawn of fiscal concessious on small savings and provident funds, such measures have not
been suggested by them in mutual funds and equities.
An increase in the short-term deposits of banks leads to increase in money supply and liquidity in the
economy. Conversely, an increase in long-term deposits implies an increase in savings. So there is a
relationship between interest rate and economic progress exists in an economy like India.

MARKET SEGMENTATION THEORY

Culbertson introduced this theory. Later economist Lutz called it as the theory of risk avoidance.

ASSUMPTIONS:
 (1) Investors are always risk averters therefore risk reducer.
(2) Investors make balance between assets and liabilities to avoid risk.
(3) Securities market is divided into small segments.
(4) Different term securities are complete substitute of each other.

EXPLANATION: term structure of interest rate is determined through supply and demand of securities in this
theory. If the lenders have more demand for long-term and short-term capital and investors like to invest in
short-term securities, in that case interest rate for long-term securities will be higher than that of short-term
securities. On the other side, lenders have less demand of long-term loans and if investors are eager to invest
on long-term basis, the long-term interest rate will be lower than short-term interest rate. So, this can be said
that term of securities plays significant role to determine interest rate.

CRITICISMS:
(1) That the borrowers and lenders will be always able to avert risk on their desire cannot be always
accepted. Investors will keep vigil on their income.
(2) This is not always acceptable that investors will by any means afford to avert risks.