Different Types of Interest Theories

Over the period of time different interest theories have been seen. Basic purpose of these theories is to explain the meaning of interest more precisely, specifically and easily.

Let’s check below these theories of interests one by one in more detail to know their specific meaning and purpose.

Table of Contents

Different Types of Theories of Interest

Economic Theory

Interest Theory: The demand & supply of funds meet at interest rate which is an equilibrium price & expressed in percentage terms.

In other words, interest rate is the rate at which buyers are ready to buy & lenders are willing to lend. But interest rate (equilibrium price) differs from one market to another.

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For example, the “price” of capital in cotton market is different from the “price” of capital in property market. The supply & demand of funds in the market control the market interest rates which are different.

All the markets in the country and the interest rates predominant there are interlinked, although the interest rates in the different markets may differ.

In the present day business environment, it is significant to understand the factors that make up an interest rate. With the help of following factors, the nominal rate of interest is determined.

i = iRF + g + DR + MR +LP + SR
i is the nominal interest rate usually quoted in documents. i – g is the “real” interest rate.
Here i = market interest rate
g = rate of inflation
DR = Default risk premium
MR = Maturity risk premium
LP = Liquidity preference
SR = Sovereign risk

Following is the explanation of these determinants of interest rates.

Risk Free Interest Rate (RF): Because no investment can be entirely risk-free, therefore, there is factually no such thing as risk-free rate of return. A certain amount of risk is included in all investments & securities.

A business organization may close down or bankrupt. Since the chances of default of a government are minimal, so the government-issued securities are considered as risk-free.

For the determination of interest rates, these government issued securities provide a benchmark. The US T-bills are viewed as risk free rate of return, internationally.

Inflation (g): In the nominal interest rate, the expected average inflation over the life of the security or investment is generally instilled by the issuer of security to cover the inflation risk.

The rate of inflation is added to the real interest rate while quoting nominal interest rates by the issuer in order to secure the investor against inflation.

Default Risk Premium (DR): The risk that the business organization might close down or go bankrupt and shares or bonds issued by the business organization may collapse is considered as default risk.

Investor charge the default risk premium as a compensation against the risk that the business organization might goes bankrupt.

On interest payments, business organizations may also default which is not unusual in corporate world. In USA rating agencies like S&P and Moody’s grade securities ratings from best to worst are AAA, AA, A, BBB, BB, B, CCC, CC, C.

Maturity Risk Premium (MR): The maturity risk premium is associated with the life of particular security. Maturity risk premium is associated to the life of investment. The higher the maturity risk is, the longer the maturity period will be.

Sovereign Risk Premium (SR): The risk of government default on debt because of economic or political turmoil, trade deficits, war and prolonged budget.

This risk is also associated with the depreciation, foreign exchange and devaluation. Billions of rupees are invested globally now-a-days by individuals and institutions.

In case a bank desire to invest in Pakistan, it will have to consider the economic, political and financial environment.

The bank would be willing to lend at a higher interest rate if the bank sees some risk involved it. The sovereign risk premium is added to the interest rate, therefore, the interest rate would be high.

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Liquidity Preference (LP): Easily en-cashable securities are preferred by the investors. For forgoing the liquidity of the investors, they charge the borrowers. The interest rates would always pushed upwards by a high liquidity preference.

Yield Curve Theory

Term Structure & Yield Curve: Across time horizon, interest rates for any security vary. Depending on how long the funds are required, the supply & demand for funds vary.

Generally long term interest rates are higher than short term interest rates. In other words, on the term structure, interest rates depend. The securities can be divided into three categories on the basis of maturity.

Short Term: The period of one year or less is considered as short term.
Medium Term: The period contains one year to five years is considered as medium term.
Long Term: The period between fifteen years to twenty years is considered as long term.

Nominal or Upward Slopping Yield Curve: On the basis of how long funds are needed, the supply & demand of funds or capital varies. Long term interest rates are different from short term interest rates.

Because investors think that inflation is going to increase, therefore, normally short term interest rates are lower than long term interest rates.

Abnormal or Downward Slopping Yield Curve: In some cases, the reverse is true. This is referring to as Abnormal Yield Curve (or Downward Slopping).

In this case long term interest rates are lower than short term interest rates. Humped Back Curve or mixed curve can also be obtained. In order to determine the slope of the yield curves, following are some of the factors.

Expectation Theory

The normal shaped yield curve is rise because investors normally expect inflation (and interest) to rise with time.

Liquidity Preference Theory

Investors favor securities which have short maturities and are easily en-cashable. As for short term securities, it is not guaranteed that they get renewed at maturity that is the only problem for short term securities.