Interest Rate Overview and Influencing Factors

Study Notes

Interest rate represents the cost of money, which is the compensation a lender expects from a borrower.
It’s the cost of borrowing money and the additional cost on top of the principal amount.
The higher the risk, the higher the interest rate, as lenders want to be compensated for potential losses.
A required return is the minimum return an investor expects for their investment. It applies to equity investments like common stocks giving ownership to the investor.
Required return reflects the potential appreciation in the price of stocks, known as capital gains.

Inflation: When inflation rises, the value of money decreases, causing lenders to demand higher interest rates to compensate for the declining purchasing power of their future repayments.
Risk: Higher risk associated with borrowers or investments leads to higher interest rates to compensate for the increased likelihood of default or loss.
Liquidity Preference: Individuals prefer to hold assets easily convertible to cash, leading to a higher interest rate for long-term bonds that lock in funds for a longer period.

Real Interest rate: The rate adjusted for inflation, reflecting the true cost of borrowing or return on investment after accounting for inflation.
Nominal Interest Rate: The advertised and stated interest rate charged or earned, representing the actual rate without considering inflation.

This refers to the relationship between interest rates and the maturity of bonds with similar risk levels.
A yield curve illustrates this relationship by graphing the maturity of bonds against their corresponding interest rates.

Normal Yield Curve: An upward-sloping curve, indicating that long-term interest rates are typically higher than short-term rates due to the longer exposure to risk.
Inverted Yield Curve: A downward sloping curve, implying short-term interest rates are higher than long-term rates, possibly indicating economic uncertainty or anticipation of future rate decreases.

This theory suggests that long-term and short-term interest rates are not connected due to differences in the investors targeting each segment of the market.
This means that market forces and investor preferences can heavily influence the rates for specific maturity segments, creating independent movements in rates across different durations.