2-6
FINANCIAL MARKETS AND INTEREST RATES
Characteristics
affecting the
cost of money
There are two basic investor characteristics that affect interest rates,
or the cost of money:
1) The rate of return investors expect to realize on their
investment opportunities
Those who borrow money are unlikely to pay a higher rate than
the expected return on the investments they plan to make with
the borrowed money.
2) The preference of consumers (those who have money to either
save or spend) to forego current consumption in favor of future
consumption
Those who save will defer consumption if the rates of interest
offered by borrowers are attractive. High offered rates for
savings lead to higher levels of savings and lower levels of
spending.
Let's look at some of the factors that influence the level of interest
rates.
Calculating Interest Rates
Offered rate
of interest
The stated or offered rate of interest (r) reflects three factors:
·
Pure rate of interest (r
*
)
·
Premium that reflects expected inflation (IP)
·
Premium for risk (RP)
Each of these factors increases the stated interest rate. The resulting
interest rate calculation is:
r = r* + IP + RP
Let's examine the significance of each of these factors.