Interest rate

INTEREST RATE:

A rate of money charged or paid for the use of money. An interest rate is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. Interest rates often change as a result of inflation and Federal Reserve Board policies.

For example:

If a lender (such as a bank) charges a customer $90 in a year on a loan of $1000, then the interest rate would be 90/1000 *100% = 9%.

FACTORS AFFECTING THE INTEREST RATE

·         Term of loan

·         Inflation

·         Economic conditions

·         Foreign exchange market activity

·         Financial and political stability

·       Due to higher reserve requirements for banks

In general, interest rates rise in times of inflation, greater demand for credit, tight money supply, or due to higher reserve requirements for banks. A rise in interest rates for any reason tends to dampen business activity (because credit becomes more expensive) and the stock market because investors can get better returns from bank deposits or newly issued bonds than from buying shares.

Term of loan: Is it short or long term? Short-term loans (overnight or up to a year) normally have lower interest rates because it's easier for the lender to predict future market conditions like inflation and economic growth.

Lenders tend to charge higher interest rates on long-term loans because they are taking a risk on future economic conditions. If they don't protect themselves against rising interest rates set by the Bank of Canada, they can lose money on the loan in the long term.

Inflation: Inflation refers to the general increase in prices. Inflated prices mean that money is not as valuable and lenders are concerned about prices increasing in the future.

For example: A bank loans you $2,000 today and over the next year prices increase by 5 per cent. When you repay the $2,000 a year from now, its purchasing power will be less. In essence, you'll be repaying cheaper dollars than the ones you borrowed. So lenders add an assumed inflation rate into the interest rate you will pay.

The inflation rate affects interest rates. When the loan is sought for a long period of time, the lender needs to safeguard its interests. With the passage of time, the purchasing power of the currency goes down. Therefore, the lender would try to recover all the money lent by charging an inflationary premium on the money lent.

Thus, inflation and the rate of interest have a direct relationship. When inflation rises, interest rates also rises.

Federal Reserve

The Federal Reserve can influence interest rates by setting the discount rate, the rate that banks pay for short-term loans from the Federal Reserve. It also can influence interest rates by making changes to the money supply.

Currency Values

If a country enjoys a positive balance of trade, the value of its currency, relative to other currencies, usually rises. A country that sells more of its products and services to other countries than it purchases from them has a positive balance of trade. This can have an effect on interest rates in that country. An increase in the value of that country's currency makes its goods more expensive for other countries to buy. Lowering interest rates tends to stop the rise in a country's currency's relative value so its exports remain affordable to other countries.

Benefits of high and low inters rate:

On the macroeconomic level, high interest rates are meant to discourage investment. They are used as a means to control an economy that is growing too quickly and treating to slip into inflation.

Low interest rates encourage investment, and are used to promote economic growth.

INTEREST RATE RISK:

           The possibility of a reduction in the value of a security, especially of a bond, this risk can be reduced by diversifying the duration of the fixed-income investments that are held at a given time.

Purpose of Interest Rate:

In short words the purpose of interest rate is to earn profit.

In business, money is used to make money. A business can make money by operating a retail store, a restaurant, or any other kind of business and sell things for a profit. If you loan money to someone the interest is the way you make money from that loan. Without profits there would be no reason for any store, restaurant, bank, or any other kind of business.