What is Interest rate?
An interest rate is the price a borrower (the person who borrows money) pays for the use of money they do not own. For example a person might borrow from a bank to fulfill any of his personal needs, and the lender will receive a return for postponing the use of funds, by lending it to the borrower, this return is called interest. Interest rates are normally expressed as a percentage rate over the period of one year such as 8% per annum, 10% per annum etc.
Causes of Interest Rates
Following are the major causes of interest rate changes;
- Deferred consumption
- Inflationary expectations
- Alternative investments
- Risks of investment
- Liquidity preference
When money is loaned the lender delays spending the money on consumer goods, since according to time preference theory people choose goods now to goods later, in a free market there will be a positive interest rate.
Most economies generally show inflation, it means a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. It means if the economy indicates any sign of inflation the possibility of increase in interest rates will be more.
The lender has a choice between using his money in different investments. If he chooses one, he misses the returns from all the others. Different investments effectively compete for funds.
Risks of investment
There is always a risk that the borrower will go bankrupt or otherwise default on the loan. This means that a lender generally charges a risk premium to make sure that, across his investments; he is compensated for those that fail.
People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.
Because some of the gains from interest may be subject to taxes, the lender may be firm on a higher rate to make up for this loss.
Impact of Interest Rate changes in the Stock Market
Why do interest rates have such a big impact on the stock market? There is always an inverse relationship between the interest rates and stock market. Generally if the interest rates are going high the stock market will fall and vice versa. There are a number of reasons why the inverse relationship between interest rates and stock prices holds. The three main ones are associated with the impact rates have on;
- Macroeconomic conditions
- Attractiveness of equity as an Asset Class
- Cost of transacting.
Low interest rates are good for business, it makes it cheaper to borrow funds, invest in new projects, expand supply, etc. Low interest rates also increases consumption as debt finance becomes cheaper and people’s disposable income rises as existing interest payments are reduced. A decrease in interest rates therefore increases revenue expectations for most businesses. Assuming a relatively gentle inflationary environment, this increases expected earnings, pushing up company valuations and stock prices. Of course an increase in rates has the opposite effect by reducing earnings expectations and pushing stock prices downwards.
An increase in interest rates makes equity relatively less attractive as an asset class because the risk-free return available elsewhere increase. When there is an increase in interest rates the interest on deposit also will increase. It will make the equities less attractive. As interest rates go up, new issues of government securities are made at a higher premium rate. This means that the risk premium associated with the stock market, the reward for taking the extra risk of buying equity, declines.
Cost of transacting
Much of the volume in the markets these days, whether retail or institutional, is made ‘on margin’. This means that initially the investor only has to put up a small portion of the funds needed to buy shares and the remaining funds are loaned by the broker on a short term basis. An increase in interest rates increases the cost of margin trading. As the cost of trading increases, marginal profit opportunities begin to look less attractive and as a result demand volume is reduced and the price of shares falls. On the other hand a reduction in rates makes margin trading more affordable, increases the number of buyers in the market and pushes the price up.
If a banks are paying as high as ten per cent in interest for cash deposit annually, lots of people will prefer to deposit their money in that bank than investing in the stocks as well as mutual funds this will affect the stock market very badly.
Change interest rates will have a major impact on two sectors such as;
Increase or decrease in interest rate will directly affect the automobile industry because a majority of people are depending on car loans or two wheeler loans for buying vehicle. So if the interest rates are increasing, people won’t be able to afford this and normally the demand for automobiles will come down this will have a very bad impact on the industry.
Real estate industry is closely related to the interest rates. A small change in the interest rate can influence the performance of the industry. If there is an increase in interest rate the demand for real estate will come down because a large portion of real estate investors are taking the support of bank loans for investment. Normally if the interest rate goes up they won’t be able to take a loan and invest. This will lead to the negative growth of the industry. If the interest rate in decreasing, it will help to boost the industry’s performance.