INTEREST RATE AND ITS

ROLE IN FINANCE
The earnings on money lent and the cost of
borrowed are expressed as percentage of the
principal amount of money lent or borrowed is
called interest rate.

It is, therefore, clear that interest rate plays a

major role in finance as it affects various
economic factors like
It is, therefore, clear that interest rate plays a
major role in finance as it affects various
economic factors like demand for money
(motives for holding money) and the velocity of
money (the frequency of spending or the rate of
turnover of money).
The level of investment spending, level of
consumer expenditures, redistribution of wealth
between borrowers and lender, and prices of
financial securities, are among the ones affected
by any changes in the interest rate.
Transaction demand is the money needed to
accommodate a firm’s expected cash
transactions.
Precautionary demand is the demand for highly
liquid financial assets ─ domestic money or
foreign currency ─ arising from preparedness for
emergency expenditures.
Speculative demand is the demand for highly
liquid financial assets ─ domestic money or
foreign currency ─ that is not dictated by real
transactions such as trade or consumption
expenditure. Speculative demand arises from the
perception that money is optimally part of a
portfolio of assets being held as investments.
Whatever reasons people have for holding on to
money, they may change when interest rate
changes.

FIGURE SHOWS
INTERRELATIONSHIP AMONG
INTEREST RATE, DEMAND FOR
MONEY, AND VELOCITY OF MONEY
INTEREST DEMAND VELOCITY
RATE FOR OF
MONEY MONEY
Interest rate is one of the most crucial variables in
macroeconomics, as well as in the practical
world of finance.
 The Difference Between Interest Rate and Rate of
Return
Sometimes, interest rate and rate of return are interchangeably used;
however, there is a big distinction between the two. As previously
discussed, interest rate is the cost of using money expressed as a
percentage of a principal for a given period of time, which is usually
per year, while rate of return (ROR) is defined as the yield to the
owner, plus the change in its value, expressed in relation to its
purchase price. For financial asset, ROR is generally the change in
value in addition to any direct income derived from the financial
asset.
To illustrate, let us take an investment in bonds of ₱10,000
with interest rate or coupon rate of 10% and a change in value
at the end of the year after acquisition of ₱11,000:

Interest rate is computed as,

Interest I

Face Value FV

Where,
I is the interest.
FV is the price of the bond.
In our example, therefore, the interest rate is computed as
follows:

1,000
Interest Rate   10%
10,000
ROR is the interest received from the bond the change in value of the
bond or rate of capital gain. The rate of capital gain is the
difference between face value and its market value compared to its
face value. The computation for the ROR in our example is as
follows:

MV FV
ROR  Interest Rate 
FV
Where,
MV is the market value.
FV is the face value.
Therefore,

11,000  10,000
ROR  10% 
10,000
1,000
 10% 
10,000
 10%  10%
 20%
 The first part in the computation of rate of return is the
interest rate (current yield) and for the part is the rate of
capital gain. In our illustration, the 10% is the interest
rate and the other 10% is the rate of capital gain as a
result of increase in value, making the total yield equal to
20%. If the bond has decreased in value (capital loss),
say from ₱10,000to₱9,000,thesecondpartwillgiveus:

10,000  9,000 (1,000)

Rate of Change In Value    (10%)
10,000 10,000
 The rate of change in value is negative indicating loss.
Therefore, the ROR would be:

Interest
ROR  10% ( )  (10%)(Rate of Capital Loss)
CouponRate
 0%
The investor earned 10% interest but lost 10% due to the
decrease in the value of the bond, making the net yield to
the investor equal to zero (0%). What the investor earned
in terms of interest was entirely lost due to the decrease
in value.
Apparently, the return on a bond will not
necessarily equal to the interest rate on the
bond. Even for a bond for which the current
yield is an accurate measure of the yield to
maturity, the return can differ substantially from
the interest rate, especially if there are sizable
fluctuations in the price of the bond that
produces substantial capital gain or losses.
The key findings which are generally true of all bonds according to
Mishkin (2003) are as follows:

a. The only bond on which return equals the initial yield to

maturity is one on which time to maturity is the same as the
holding period, which means the investor holds the bond to
maturity.

b. A rise interest rate is associated with a fall in bond prices,

resulting in capital losses on bonds which terms to maturity
are longer than the holding period, which means the investor
holds the bond and sells the same prior to maturity.
c. The more distant as bond’s maturity, the greater the size of the
percentage price change associated with an interest-rate
change.

d. The more distant as bond’s maturity, the lower the rate of

return that occurs as a result of the increase in the interest
rate.

e. Even though a bond has a substantial initial rate, its return can
turn out to be negative if interest rate rises. When interest
rate rises, market price of financial asset generally falls. This
is the another inverse relation between interest rate and
market price of securities.