Chapter 5 - Introduction to fundamental analysis
The Most Important Economic Indicators - Interest Rates
What Is the Interest Rate?
The interest rate is defined as the ratio of the borrowed amount that the lender charges as interest from the borrower, and is usually expressed as an annual percentage. It is the price that the bank or other lenders is paid for borrowing its money, or the price the bank pays for the savings to keep the money in the account.
Interest rates are usually used for personal loans and mortgages, although they may extend to loans for the purchase of cars, buildings, and consumer goods.
Lenders usually offer lower interest rates for low-risk borrowers, and higher rates for high-risk borrowers. While lenders usually set their own rates, competition for borrowers means that lenders in a specific area usually provide comparable numbers.
Regardless of the borrower's risk assessment, several external factors may influence current interest rates. These usually include inflation, low money supply or high demand for credit.
When interest rates rise, the economy may get worse due to a lack of affordable credit. Interest rates can affect corporate earnings and government monetary policies.
Factors Affecting Interest Rates
Interest rates vary according to the following:
- Government directives to the central bank to achieve government goals.
- Currency of the principal lent or borrowed amount.
- Investment maturity.
- The perceived hypothetical possibility of the borrower.
- Market supply and demand.
- Amount of guarantee.
- Special features like call provisions.
- Backup requirements.
- Compensatory balance.
as well as some other factors.
The company borrows capital from a bank to purchase assets for its business. In return, the bank charges interest from the company. (The lender may also require rights to the new assets as guarantee).
The bank will use the capital deposited by individuals to provide loans to their clients. In exchange, the bank must pay interest to the individuals who deposited the capital. The amount of the interest payment depends on the interest rate and the amount of capital you deposit.
The base rate usually refers to the annual rate submitted on overnight deposits by the central bank or any other monetary authority.
The annual percentage rate (APR) and actual annual rate or annual equivalent rate (AER) are used to help consumers compare products with different payment structures on a co-basis.
The discount rate is applied to calculate the present value.
For interest bearing securities, the coupon rate represents the ratio of the annual coupon amount (annually paid coupon) per unit of face value, while the current yield is the ratio of the annual coupon divided by the current market price. Yield to maturity is the security expected internal rate of return, assuming that it will be held until maturity, i.e. the discount rate that is equal to all the remaining cash flows of the investor (all the remaining vouchers and the face value of the maturity value) with the current market price.
Depending on the banking business, there is the deposit interest rate and the loan interest rate.
Depending on the relationship between supply and demand of the market interest rate, there is a fixed interest rate and a floating interest rate.
Depending on the changes between the different interest rates, there is the base interest rate and the monetary interest rate.
Interest rate targets are a vital tool of monetary policy and are taken into account when dealing with variables such as investment, inflation, and unemployment. Countries central banks generally tend to lower interest rates when they want to increase investment and consumption in the country economy. However, a low interest rate as a macroeconomic policy may be risky and could lead to the creation of an economic bubble, as large amounts of investments are being pumped into the real estate and stock market. In advanced economies, adjustments are made to interest rates to keep inflation in a target range for the health of economic activities or the maximum interest rate in conjunction with economic growth to protect the economic momentum.
The Change in Interest Rates Throughout History
In the past two centuries, interest rates have been set differently by either national governments or central banks. For example, the federal funds rate in the United States ranged between 0.25% and 19% from 1954 to 2008, while the Bank of England's base interest rate ranged between 0.5% and 15% from 1989 to 2009, [Germany lived with rates close to 90% in the 1920s to about 2% in the 2000s]. During an attempt to tackle runaway inflation in 2007, the Zimbabwe Central Bank increased borrowing interest rates to 800%.
Interest rates on primary credits in the late 1970s and early 1980s were much higher than they were recorded; Higher than the previous peak in the United States since 1800, from British summits since 1700, or from Dutch summits since 1600; “Since the modern capital markets came into being, there have never been such long-term rates" as in this period.
Perhaps before modern capital markets such as the "Forex" foreign exchange market, there were some accounts that could achieve a savings deposits annual return of at least 25% and up to 50%.
Reasons for The Changes
- Short-Term Political Gains: Lower interest rates can give the economy a short-term boost. Under normal circumstances, most economists believe that lowering interest rates will only result in a short-term gain in economic activity that will soon be offset by inflation. A quick boost can affect the elections. Most economists advocate independent central banks to limit the impact of policy on interest rates.
- Deferred Consumption: When the money is loaned, the lender delays spending the money on consumer goods, since according to the time preference theory, people now favour goods over commodities. Later, in the free market, there will be a positive interest rate.
- Inflationary Expectations: Most economies generally show inflation, which means that a certain amount of money will buy less in the future than it does now. The borrower needs to compensate the lender for this.
- Alternative Investments: The lender has the option of using his money in different investments. If he chooses one, he forgets the returns from the others. Various investments compete effectively for money.
- Investment Risks: There is always a risk of the borrower going bankrupt, escaping, dying, or otherwise defaulting on the loan. This means that the lender generally receives a risk premium to ensure that, through his investment, he is compensated for those who fail.
- Liquidity Preference: People prefer making their resources available in a form that can be exchanged immediately, rather than in a format that takes time to achieve.
- Taxes: Because some interest gains may be taxed, the lender may insist on a higher rate to compensate for this loss.
- Banks: Banks may tend to change interest rates either to slow or accelerate economic growth. This includes either raising interest rates to slow the economy or lowering interest rates to encourage economic growth.
- Economics: Interest rates can fluctuate according to the state of the economy. It will generally appear that if the economy is strong, interest rates will be high, and if the economy is weak, interest rates will be low.
Manipulating interest rates is deemed a large part of national monetary or fiscal policy, one of the main functions of central banks, this is because interest rates are a great level for the economy. Interest rates may be stronger than any other factor, and they affect currency values. It can have an impact on inflation, investment, trade, production and unemployment.