Over the period of time, different interest theories have emerged. The basic purpose of these theories is to explain the meaning of interest more precisely, specifically, and clearly. Let’s explore these theories of interest one by one in more detail to understand their specific meaning and purpose.
Different Types of Theories of Interest
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Economic Theory
Interest Theory:
The demand & supply of funds meet at the interest rate, which is an equilibrium price expressed in percentage terms. In other words, the interest rate is the rate at which borrowers are ready to borrow & lenders are willing to lend. However, the interest rate (equilibrium price) differs from one market to another.
For example, the “price” of capital in the cotton market is different from the “price” of capital in the property market. The supply & demand of funds in each market determine the interest rates, which may vary. All the markets in a country and the interest rates prevailing there are interlinked, although the rates may differ across markets.
In the present-day business environment, it is important to understand the factors that determine an interest rate. With the help of the following factors, the nominal rate of interest is determined:
i = iRF + g + DR + MR + LP + SR
Where:
i = nominal (market) interest rate
g = rate of inflation
DR = default risk premium
MR = maturity risk premium
LP = liquidity preference
SR = sovereign risk
Also, i – g represents the real interest rate.
Risk-Free Interest Rate (RF)
Since no investment is entirely risk-free, there is practically no such thing as a completely risk-free rate of return. A certain amount of risk is present in all investments & securities.
A business organization may shut down or go bankrupt. However, since the chances of default by a government are minimal, government-issued securities are generally considered risk-free.
These securities provide a benchmark for determining interest rates. For example, US Treasury Bills (T-bills) are commonly viewed as the risk-free rate internationally.
See Also: Basic Concepts of Financial Management
Inflation (g)
The expected average inflation over the life of a security is usually included in the nominal interest rate to cover inflation risk. The issuer adds the inflation rate to the real interest rate while quoting the nominal rate in order to protect investors against inflation.
Default Risk Premium (DR)
Default risk refers to the possibility that a business organization may shut down or go bankrupt, causing its bonds or shares to lose value. Investors charge a default risk premium as compensation for this risk.
Organizations may also default on interest payments, which is not uncommon in the corporate world. In the USA, rating agencies such as S&P and Moody’s grade securities from best to worst as AAA, AA, A, BBB, BB, B, CCC, CC, and C.
Maturity Risk Premium (MR)
The maturity risk premium is associated with the life of a particular security. It increases with the length of the investment period. In simple terms, the longer the maturity period, the higher the maturity risk.
Sovereign Risk Premium (SR)
Sovereign risk refers to the risk of government default due to economic or political instability, trade deficits, war, or prolonged budget issues. This risk is also associated with currency depreciation, foreign exchange fluctuations, and devaluation.
Nowadays, billions of rupees are invested globally by individuals and institutions. For example, if a bank wants to invest in Pakistan, it must consider the economic, political, and financial environment.
If the bank perceives higher risk, it will demand a higher interest rate. Therefore, sovereign risk premium increases the overall interest rate.
Liquidity Preference (LP)
Investors prefer securities that are easily convertible into cash. To compensate for giving up liquidity, they charge borrowers a premium. Higher liquidity preference generally pushes interest rates upward.
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Yield Curve Theory
Term Structure & Yield Curve
Interest rates for a given security vary over different time horizons. The supply & demand for funds depend on how long the funds are required.
Generally, long-term interest rates are higher than short-term interest rates. In other words, interest rates depend on the term structure. Securities can be classified into three categories based on maturity:
- Short Term: One year or less
- Medium Term: One to five years
- Long Term: Fifteen to twenty years
Normal or Upward Sloping Yield Curve
The supply & demand for funds vary based on the duration for which funds are needed. As a result, long-term interest rates are usually higher than short-term rates. This is because investors expect inflation (and interest rates) to rise over time.
Abnormal or Downward Sloping Yield Curve
In some cases, the opposite occurs. This is known as an abnormal or downward sloping yield curve. In this situation, long-term interest rates are lower than short-term interest rates. A humped or mixed yield curve can also occur. The slope of the yield curve depends on several factors.
Expectation Theory
According to this theory, a normal upward-sloping yield curve exists because investors expect inflation and interest rates to increase in the future.
Liquidity Preference Theory
Investors prefer short-term securities because they are more liquid and easily convertible into cash. However, short-term securities carry the risk that they may not be renewed upon maturity, which is a key limitation.
