Real Interest Rate and Nominal Interest Rate Finance Essay

Interest is defined as the price paid for the money borrowed from a lender. It is sometimes described as the reward for postponing consumption. It was considered by Classical economists as the earnings of capital; hence the marginal productivity of capital was called the rate of interest.

Real Interest rate and Nominal Interest rate

The nominal rate of interest is the annual rate that must be paid on borrowed funds. It is the rate of interest, which is quoted in all financial market. However, the real rate of interest takes account of inflation. In order to calculate the real rate of interest we simply deduct the rate of inflation from the nominal rate of interest. It can be described properly by the Fisher equation. 1 + i = (1 + r) (1+E(I)) Where; i is the nominal interest rate, r is the real interest rate, E(I) is the expected inflation rate.

THEORIES OF INTEREST RATE

The Classical Theory

The classical theory explains interest rate in relation to demand and supply on savings. It suggests that demand comes from those in need of money, for example investors and entrepreneurs, and supply comes from those who are restricting their consumption in order to save their incomes. Interest is viewed as a reward for the savings of their incomes.

Interest is a price for abstinence

It was Nasau Senior who first claimed that interest was the price paid for the sacrifice involved in savings. According to him, it is the willingness of the consumer that determines whether he or she will abstain from consumption in order to make savings. Therefore interest act as a compensation for the individual to abstain from consumption. However Karl Marx, an economist, argued that the main source of savings comes from rich people and they do not need to undergo the sacrifice of abstinence in order to save. So Marshall substituted the term 'waiting' for 'abstinence' and interest is the reward for the sacrifice of postponing consumption when an individual saves money since it does not abstain completely from consumption.

The Agio Theory

Another explanation proposed by Bohm-Bawerk was that people prefer present enjoyment to future enjoyment on goods of the same kind and quality which means there is an agio or premium on the present goods. In order to encourage people to skip the enjoyment of present goods, interest must be paid to them. Three reasons put forward by the economist were: People tend to underestimate the future wants. Present wants are felt more strongly than future wants. Present goods possess a technical superiority over future goods.

Fisher's Theory (Time Preference Theory)

Irving Fisher emphasized much on time preference as the cause of interest and he also considered marginal productivity of capital (rate of return over sacrifice) as a factor that determines interest. He defined interest as the compensation for the time preference of an individual. Time preference is the preference of having the same amount of goods and services at one time instead of some other time. The greater the preference of individual for the present enjoyment of good, the higher will be the rate of interest paid to persuade them to lend the money. The time preference depends on the following factors: Size of income: Large incomes imply less time preference which means a relatively lower rate of interest rate. Distribution of income over time: If income increases with time, people will be impatient to spend in the present and thus time preference will be greater. Degree of certainty regarding enjoyment in the future: If someone is sure of future enjoyment, the latter will not be willing to spend in the present, therefore the time preference will be less.

Liquidity Preference Theory of Interest Rate

Keynes pointed interest as the reward for separating with liquidity for a specified period of time in his book "The General Theory of Employment, Interest and Money." He explains liquidity preference as the desire for someone to save cash, in other words which leads to the demand for money. The three motives from which demand for money arises are:

Transactions motive:

It refers to demand for money for current transactions of individuals or firms. This demand depends on: Size of income: If income is high. This implies that there will be more transactions. Time gap between receipts of income: The greater the time gap will induce a greater demand for money. Spending habit: If a person has the habit of spending, he will perform more transactions and therefore demand for money will be greater.

Precautionary motive:

It relates to the holding of cash balances of a firm or individual to meet unexpected incidents, for example accidents. Factors that affect this type of demand are: Size of income: A greater size of income will cause more to be preserved for the future. Nature of the person or firm: It depends whether the person or firm is optimistic or pessimistic and this will determine whether the demand for precautionary motive will be high or less. Rationally pessimistic firms will want to have more cash with them. Farsightedness: Usually a farsighted person or firm can have a good prediction of the future. If he/it expects fewer tragedies, he/it will keep less money with him. The demand for money for both transaction motive and precautionary motive are completely interest inelastic.

Speculative motive:

It refers the holding of resources in liquid form so as to take advantage of the rise and fall in prices of bonds and securities. According to Keynes, rate of interest is inversely proportional to bond prices. For instance, if bond price is expected to rise, normally investors will hold less money and will purchase bond in order to sell it when its price will increase.

Determination of Interest Rates

The classical theory determines interest rate by the demand of savings and supply for savings. Supply for savings depends on the abstinence of the savers whereas demand for savings depends on willingness of investors to invest in capital products. Rate of interest is determined by the intersection (E) of investment curve (II) and supply of savings curve (SS).

Determination of the Rate of Interest through the Supply of Money and Interaction of Liquidity Preference

According to Keynes, rate of interest is determined by the supply of money and liquidity preference which is the demand for money. The supply of money is usually determined by the policies of Government and the Central Bank of a country. It is perfectly inelastic The curve 'LP' is the liquidity preference which is the demand for money. The money supply curve is 'S'. The equilibrium rate of interest is the point 'E' and at any interest above 'R', there will be an excess of money supply according to the demand for money. This will lead to a decrease in interest rate. There is a situation called the liquidity trap where changes in money supply does not influence the interest rate

Direct intervention of Central bank.

Central bank may directly intervene by imposing maximum or minimum prices of loans; depending on whether it wants to protect the money borrower or money lender. If the Central Bank fixes a minimum rate of interest, the intervention is to cheapen loans. It acts in favour of the borrowers. They pay a cost which is at the minimum price although maximum rate of interest may create shortages of loans. This is so because demand for loans is greater than supply of loans. If Central Bank fixes a maximum rate of interest, the measure is to protect the money lenders - this guarantees them a higher market rate of interest although this may lead to a surplus of loans.

Indirect intervention of Central bank through repo rate/ bank rate/ Lombard rate.

The repo rate is the rate at which the central bank lends money to the commercial banks. Hence, repo rate is a cost to the suppliers of loans. Following an increase in repo rate, in order to maintain the spread, commercial banks will also increase their rate of interest; which also implies that following a fall in repo rate, commercial banks may reduce the rate of interest. Lombard rates provided by the Central Bank are rates that are charged for credit to banks. The Central Bank offers banks loans which they use to lend borrowers. The Central Bank usually set Lombard rates a little above standard rates. In order to make profit, the banks charge the borrowers an interest which above the Lombard rate and hence hedge against any loss on securities.

Inflation rate.

Following an increase in inflation rate and assuming the market rate of interest remaining unchanged, the real rate of interest will fall; which is a deterrent to save. Therefore, in order to maintain a positive real rate of interest, the market rate of interest has to be increased during inflation. Therefore the relationship is that interest rate increased as a result of inflation.

The banking market structure.

Here, a question needs to be asked. Is it a highly perfectly competitive or an imperfect banking market? If it is an imperfect banking market in form of a monopoly, duopoly, oligopoly it is not in favour of a borrower's market. Mauritius is an oligopolistic sector having 2 main players. Hence, it becomes a lender's market where they can resist any signal by the central bank through its repo rate.

The rate of interest of trading partners influencing the domestic rate of interest.

The rate of interest practiced by the trade partners may influence the domestic rate of interest. Following the liberalization of the capital account on the balance of payments, there is an unrestricted inflow and outflow of short -term investments which can be in terms of portfolio investments. If trade partners increase their rate of interest and the Mauritian economy maintains the same rate, there may be a net outflow of portfolio investments which will affect the supply of the Mauritian currency by depreciating it.

Interest Rate Risk

Interest rate risk is the risk associated with movements of interest rate in the net income and economic value of an institution. The Fed gazette pointed interest rate risk as the blood pressure for banks. This is so because banks normally act as financial intermediaries, that is, they accept deposits which they turn into loans with different maturities and interest rates. These activities result in an exposure which is the interest rate risk. Therefore it is important to have an efficient risk management that preserves interest rate risk at sound levels.

Sources of Interest Rate Risk

Being financial intermediaries, there are different sources of interest rate risk that banks face. The Basel Committee differentiates among four sources of interest rate risk.

Repricing Risk

It happens where there is a time difference in the maturity usually for fixed rate and repricing for floating rate of bank liabilities, assets and off balance sheet positions. If the average yield of a bank's assets or liabilities is sensitive to changes in market interest rate, therefore the bank will normally face repricing risk. This will result in different possible mismatches. Different maturities may happen in the fixed rate of assets and liabilities. There may also be different pricing periods with floating rate assets and liabilities. This floating rate may have base rates of different maturities. It is measured by comparing the amount of bank's assets that reprice to its liabilities within the same period of time. In order to improve their earnings, some banks take this type of risk in their balance sheet structure deliberately. The current earnings performance of a bank usually gives an image of the repricing risk.

Yield Curve Risk

Yield curve risk represents the possible changes in the yield curve that can affect the bank's assets and liabilities. It implicates the changes in the relationship between interest rates of the same markets but with different maturities. According to the Basle Committee, changes in the shape and slope of the yield curve can be caused by mismatches in repricing. Unexpected shifts in the yield curve can have a negative impact on the bank's income and economic value.

Basis Risk

Basis risk arises due to changes in the relationship between interest rates from different market sectors. In a simpler term, it can be defined as the change in interest rate of one instrument in relation to another. This type of risk is also known as the spread risk. The changes in the relationship can affect the bank's current net interest margin through changes in the paid spreads of instruments that are being repriced. Future cash flows can also be affected which in turn will affect the underlying net economic value of the bank. Banks can be exposed to basis risk when they use off-balance-sheet instruments such as options, swaps and futures in order to hedge interest rate risk. The risk is that off-balance-sheet contract's cash flows may change with changes in interest rates and in relation to the positions being hedged.

Option Risk

Option gives its holder the right to sell or buy financial instrument at the strike price over a specified period of time. This risk occurs when a bank's customer has the right to alter the timing and level of flows of an instrument. Option can result with an unbalanced risk/ reward profile. The movement of interest rate is important because it will determine whether the bank will gain or lose. For example, a bank sells options to its members. The amount of earnings is favoured by the moment of interest rate. This will surpass the amount that the bank would have lost if the rate of interest moved in an unfavourable way. The bank will have more upside reward than downside exposure.

Impact of Interest Rate Risk

There are two perspectives on which a bank is assessed for its interest rate exposure. They are the earning perspective and the underlying economic value of the bank.

Earnings Perspective

Fluctuations in interest rate affect a bank's reported earnings. This perspective considers the impact of changes in the interest rate on a bank's reported earnings. The reported earnings are usually influenced through changes in a bank's net interest income. The Net interest income varies with the movement of interest rate because differences in: Timing of accrual changes which is the repricing risk, Options position, Changing rate and yield curve relationships which represent the basis and yield curve risk. In order to predict an effect in their earnings, banks usually conduct analysis such as income sensitivity or consider different scenarios on changes of interest rate.

Economic Value Perspective

This perspective considers the impact of movements in interest rate on the economic value of a bank's liabilities, assets and off- balance-sheet contracts. The economic value of a bank can be viewed as the present value of bank's expected net cash flows. This perspective identifies risk arising from maturity gaps or long term repricing. The impact of interest rate changes on the value of all cash flows, the economic perspective provides a comprehensive measurement of interest rate risk. It can also give a leading indicator of the bank's future earnings and capital values.

Measuring Interest Rate Risk

In order to have a sound management of interest rate risk, an accurate and timely measurement of it is important. It should be able to quantify and indentify the bank's major sources of interest rate risk exposure. There are different approaches in measuring interest rate risk used by banks.

Maturity Gap Analysis

This analysis distributes interest rate sensitive assets, liabilities and off-balance-sheet positions into a certain number of predefined time band according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). Its objective is to improve the net interest in the short run over discreet periods of time called the gap periods. The risk sensitive assets and risk sensitive liabilities are grouped into 'maturity buckets' based on maturity and the time until the first possible repricing due to change in the interest rates. The gap (RSG) is then calculated by considering the difference between the absolute values of the interest Rate Sensitive Assets (RSAs) and interest Rate Sensitive Liabilities (RSLs). RSG = RSAs - RSLs The three possible scenarios are: RSA > RSL = Positive Gap RSA < RSL= Negative Gap RSA = RSL = Zero Gap The Gap ratio is calculated by the formula below: Gap Ratio = RSAs / RSLs Another formula where Gap is calculated is: Where; Earning Assets = Total Assets of the Bank, NIM = Net Interest Margin, AC = Acceptable Change in NIM, Ar = Expected Change in Interest Rates.

Duration Gap Analysis

Duration is a measure of the percentage change in the economic value of a position that occurs given a small change in level of interest. It concentrates on the price risk and the reinvestment risk while managing the interest rate exposure. It also measures the effect of rate fluctuation on the market value of the assets and liabilities and net interest margin with the help of duration. Duration Gap is more difficult to measure than the simple gap model but it result in a more comprehensive measure of rate of interest rate. It also takes into consideration the time value of money. The sensitivity of the market value of assets and liabilities can be assessed using the Duration analysis. Ds x S= (DA x A) - (DL x L) Where; Ds = Duration Gap/ Duration of surplus, DA = Duration of Assets, DL = Duration of Liabilities, A = Assets, L= Liabilities, S= Surplus. Ds = DL + (A/S) x (DA - DL) L= A-S Where; AMV = Change in the Market Value, D = Duration of assets or liabilities, Ar = Change in the interest rate, r = Current interest rate, MV = Market Value.

New MV = Current MV + AMV

Simulation

It is a financial model incorporating interrelationship of assets, prices, costs, volume, mix and other business related variables. It usually stimulates performance under alternative interest rate scenarios and assesses resulting volatility in net interest income, net interest margin and so on. With this technique, the timing of cash flows are captured accurately and the interpretation is easy. It also increases the value of strategic planning. It also requires highly skilled personnel and the accuracy depends on quality of data, strength of the model and the validity of assumptions. It is also known to be time consuming.

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