Interest rates in Kenya

Definition; Refers to the price of funds. Based on treasury bills as the benchmark
rate since it is risk free.
The base lending rates of commercial banks are based on treasury bills and
prevailing interest rates.

Interest rates can also be defined by prevailing inflation rates providing real and
nominal interest rates. The nominal interest rates are the ones published while the
real interest rates are found by the differential between nominal interest rate and
the inflation expectation.

do lenders and borrowers prefer long-term or short-term interest rates?(term

structure of interest rates)
Interest rates
the required rate of return(R1) is the minimum rate of return that a project must
generate if it has to receive funds. i.e. the opportunity cost of capital (returns
expected from the second-best alternative.)
R1 = Risk free rate + Risk premium
Risk free rate is a compensation for time and is made up of the real rate (Rr) and
the inflation premium (IRp).
The risk premium is a compensation for risk of financial actions reflecting
 Riskiness of the security caused by term to maturity
 Security marketability
 Effect of exchange rate fluctuations on the security
Therefore, the required rate of return can be expressed as;
R1= Rr+ IRp+ DRp+ MRp+ LRp+ ERp+ SRp+ ORp
Where;
 Rr is the real rate of return that compensate investors for giving up the use of
their funds in an inflation free and risk-free market.
 IRp is the Inflation Risk Premium which compensates the investor for the
decrease in purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for the
possibility that users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to
maturity.
 LRp is the Liquidity Risk Premium which compensates the investor for the
possibility that the securities given are not easily marketable (or convertible
to cash).
 Erp is the Exchange Risk Premium which compensates the investors for the
fluctuation in exchange rate. This is mainly important if the funds are
denominated in foreign currencies.
 SRp is the Sovereign Risk Premium which compensates the investors for the
possibility of political instability in the country in which the funds have been
provided.
 ORp is the Other Risk Premium e.g. the type of product, the type of market
Determination of interest rate: theory of interest rate determination
Loanable model (explains how interest rates are determined through the
interaction of savers and borrowers in the financial market)- interest is the price
paid for the right to borrow and utilize loanable funds in this model.
 An increase in money supply is a source of funds to the market which a
decrease in the money market induces demand for loanable funds. Likewise,
a reduction in the demand to hold money provides a source of loanable
funds but an increase in money demand creates a demand for loanable funds.
 The supply of loanable funds come from three sources i.e. personal savings,
banking system, public sources.

Traditionally economists regard the interest as the measure of incentive to refrain

from current consumption i.e. to save. In making decision to save individuals
Substitute future consumption for current consumption
NB; The higher the interest rate the greater is the amount for future consumption.
Therefore, demand to hold money balance decreases as interest rate rises.
The demand for loanable fund is negatively related to the level of interest. That is,
the lower the interest the higher the demand for loanable funds. Interest rate moves
to the level which equates quantity of loanable funds supplied to quantity of
demand of loanable funds the point of intersection is the equilibrium.
Factors that produce a change to the equilibrium position
1. The change in supply of money or monetary policies.
2. The change in demand of money or automated overdrafts.
3. Decline in consumer confidence resulting to reduce business investment.
4. Change in price level resulting to inflation.
5. Change in consumer behavior resulting to thrift.
NB An increase in interest must be produced by either an increase in demand or
reduction in the supply of loanable funds
 1. An increase in personal saving resulting from a shift in attitude concerning
thrift would raise the supply of loanable funds and brings down the interest
rates. So will increase in business savings owing to increase in business
profit.
2. An increase in government budget surplus due to a cut in government
expenditure would result to lowering the interest rate.
3. Monetary policies which increase the supply of money would reduce interest
rate
4. A decrease in Dd for money originating from automated overdrafts would
lower interest rates.
5. Income tax hikes have a negative effect on interest rate.
6. ***Decline in business and customer confidence results to increase in
interest rates***.

Term structure of interest rates

Definition; - the relationship between the yield to maturity of bonds and its term to
maturity. It is represented graphically by the yield curve. It explains whether short
term bonds will attract higher interest rates compared to long term bonds and vice
versa.
A yield curve(shows YTM and maturity) could either be upward sloping or
downward sloping or constant.
The interest rate on a long-term bond is equal to the average of current and
expected future short-term interest rates (expectations theory). The investor is able
to choose between short term and long-term instruments.
Shapes of the yield curve
1. Normal yield curve (upward sloping); the short-term yield is lower than the
long term yield. i.e. cheaper to borrow short term than long term

2. Inverted yield curve (downward sloping); the short-term yield is higher than
the long-term yield. i.e. Borrowing short-term is more expensive than it is to
borrow long term
 3. Flat yield curve. The short-term yield is the same as the long-term yield.
cost of borrowing short-term is the same with the cost of borrowing long
term.

4. Humped yield curve. The intermediate yield is higher than both the short
term and the long-term yield. i.e. cheaper to borrow long term or short term
than it is to borrow intermediate term.

Term structure theories

 Expectation theory
States that the yield curve depends on expectation about factors affecting expected
returns on similar assets. Eg of factors; economic conditions (inflation, recession,
boom, and political condition), central bank monetary policy, government fiscal
policy, level of business activity. These factors affect interest rates.
The theory tries to explain the shape of the yield curve by explaining the
expectation implicit in yield curves. Upward sloping yield curve indicates
expectations of rising interest and vice versa. Flat yield curve indicates a constant
rate.
The entire term structure at a given time reflects the markets current expectation of
future short-term rates.
An upward sloping term structure indicates that the market expects short-term rate
to rise throughout the relevant future and vice versa.
 Liquidity preference( liquidity premium) theory.
The theory is similar to the expectation theory with only a slight modification. It
claims that the long-term interest rate should be higher than the short-term interest
rate because of;
1) Savers have to be compensated for giving up cash,( liquidity) and the longer
the period of time they have to give up the more they need to be
compensated.
2) Long term bonds are more sensitive to interest rates changes than short term
bonds. Hence the return for a longer-term bond needs to be higher than a
 shorter-term bond. In other words, returns of long-term bonds needs to
include liquidity premium to induce investors to buy them.
3) Uncertainty and volatility causes investors to favor short term investment to
long term investments such time investment are less volatile.
As a result, investors or savers need a positive liquidity or term premium to induce
them to give up their money for a period of time. The longer the period of time
they have to give up their money the larger the term premium.
This means that the forward rates should reflect both interest rate expectation and
liquidity premium which is really a risk premium, and the premium should be
higher for longer maturities.
Thus, an upward sloppy yield may reflect expectations that future interest rates
either will rise or will be flat or even fall but with a liquidity premium increasing
fast enough with maturity sourced to produce an upward sloping yield curve.
 Market segmentation/institutional/hedging theory
So, the theory set that there exist two separate markets that is long term market and
short-term market. The slope of the yield curve depends on demand and supply in
the two markets.
An upward sloping demand curve will occur if there is a large supply of funds
relative to demand in the short-term market but relative shortage in the long-term
market. Similarly downward sloping curve will indicate a strong demand in the
short-term markets compared to long term markets while a flat yield indicates
balance demand in the two markets.
According to the theory the maturity preferences of investors and borrowers are so
strong that investors never change and hence the two markets are segmented.