Author Name:   prateeksharma

This article talks about variuos structures of interest rates, role of interest rates and its genuiness in India....

Interest rate structure and it genuineness in India.

What might one conclude from the observation that longer-term bonds usually offer higher yields to maturity? One possibility is that longer-term bonds are riskier and that the higher yields are evidence of a risk premium that compensates for interest rate risk. Another possibility is that at these times investors expect interest rates to rise and that the higher average age yields on long-term bonds reflect the anticipation of high interest rates in the latter year of the bond’s life. We start our analysis of these possibilities with the easiest case: a world with no uncertainty where investors already know the path of future interest rates.

Types of interest rates:
Bond Pricing The interest rate for a given time of interval is known as SHORT INTEREST RATE for that period. Suppose that all participants in the bond market are convinced that the short rates for the next four years will follow the pattern as under given

Market participants cannot look up such sequence of short rates in The Wall Street Journal. All they observe there are price and yields of bonds of various maturities. Nevertheless, we can think of the Short Rate Sequence of the above mentioned table as the series of the interest rates that investors keep in back of their minds when they evaluate the price of different bonds. Given this pattern of rates, what price might we observe on various maturity bonds.

A bond paying Rs.1,000 in one year will sell today for Rs.1,000/1.08 = Rs.925.93. similarly a two year maturity bond will sell today at price
P = Rs.1,000 = Rs.841.75
(1.08)(1.10)

From the bond price we can calculate the yield to maturity on each bond. Recall that the yield in the single interest rate that equates the present value of the bond’s payments to the bond’s price. Although interest rates may vary over time, the yield to maturity is calculated as one “average” rate that is applied to discount all of the bond’s payments.

The yield to maturity on Zero-coupon bonds is sometimes called the spot-rate that prevails today for a period for a period corresponding to the maturity of the zero. The yield curve or equivalently, the last column thus provides the spot rates for four maturities in the table given as follow:

*The spot rates or yields do not equal the one-year interest rates for each year.

Repo Rates
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.

A repo or repurchase Agreement is an instrument of money market. Usually reserve bank (federal bank in U.S) and commercial banks involve in repo transactions but not restricted to these two. Individuals, banks, financial institutes can also participate in repurchase agreement.

Repo is a collateralized lending i.e. the banks which borrow money from Reserve Bank to meet short term needs have to sell securities, usually bonds to Reserve Bank with an agreement to repurchase the same at a predetermined rate and date. In this way for the lender of the cash (usually Reserve Bank) the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks) cash received from the lender is the collateral.

Reserve bank charges some interest rate on the cash borrowed by banks. This rate is usually less than the interest rate on bonds as the borrowing is collateral. This interest rate is called ‘repo rate’. The lender of securities is said to be doing repo whereas the lender of cash is said to be doing ‘reverse repo’.

In a reverse repo Reserve Bank borrows money from banks by lending securities. The interest paid by Reserve Bank in this case is called reverse repo rate.

Borrower of funds is called as seller of repo and lender of funds is called as buyer of repo. When the term of the loan is for one day it is known as an overnight repo and if it is for more than one day it is called a term repo.

The forward clean price of bonds is set at a level which is different from the spot clean price by adjusting the difference between repo rate and coupon earned on the security.

Bank Rate
The rate at which central banks lend funds to national banks. A central bank adjusts the supply of currency within national borders by adjusting the bank rate. When the central bank reduces the bank rate, it increases the attractiveness for commercial banks to borrow, thus increasing the money supply. When the central bank increases the bank rate, it decreases the attractiveness for commercial banks to borrow, consequently decreasing the money supply.

A bank rate is the interest rate that is charged by a country’s central or federal bank on loans and advances to control money supply in the economy and the banking sector. This is typically done on a quarterly basis to control inflation and stabilize the country’s exchange rates. A fluctuation in bank rates triggers a ripple-effect as it impacts every sphere of a country’s economy. For instance, the prices in stock markets tend to react to interest rate changes. A change in bank rates affects customers as it influences prime interest rates for personal loans.

Types of Bank Rates
Here are the different types of monetary instruments on which financial institutions offer the following bank rates:

Savings account bank rate: Modest rates are charged on funds that are deposited in the savings accounts. However, investors have high flexibility in withdrawing the deposits.

Certificates of deposit (CD) bank rate: These offer comparatively high interest rates compared to savings accounts. Bank rates on CDs are determined by the term period of a deposit and the current economic situation. The longer the term of a CD, the higher will be the bank interest rate.

Money-market funds bank rate: The interest rate on money-market funds is relatively low. As most of the money market accounts are privately insured, it is a secure method of investment. Deposits in a money market account generate interest through short-term investments.

Cash Reserve Ratio
Indian banks are required to hold a certain proportion of their deposits as cash. In reality they don’t hold these as cash with themselves, but with Reserve Bank of India (RBI), which is as good as holding cash. This ratio (what part of the total deposits is to be held as cash) is stipulated by the RBI and is known as the CRR, the cash reserve ratio. When a bank’s deposits increase by Rs100, and if the cash reserve ratio is 10, banks will hold Rs10 with the RBI and lend Rs 90. The higher this ratio, the lower is the amount that banks can lend out. This makes the CRR an instrument in the hands of a central bank through which it can control the amount by which banks lend. The RBI’s medium term policy is to take the CRR rate down to 3 per cent

The hike in CRR from 4.5 to 5 per cent will increase the amount that banks have to hold with RBI. It will therefore reduce the amount that they can lend out. The move is expected to shift Rs 8,000 crore of lendable resources to RBI. In the past few months the money that banks has available for giving out as credit is greater than the amount they have been lending out. This has led to “an overhang of liquidity” in the system. The objective of the CRR hike is to “mop up” some of the “excess liquidity” in the system.

The hike in CRR is not likely to lead to an immediate increase in interest rates. There is excess liquidity in the system even after a higher amount is deposited with RBI as reserves.

Unless the demand for credit picks up to the extent that the money is all lent out, banks will not have an incentive to raise interest rates.

The inflation rate may continue to be high, the economy may also continue to witness growth which will keep the demand for credit high, and international trends are for rates to move up. This means that sooner or later interest rates will go up. The first rates to get impacted are yields on government bonds. We have already seen this happening. If the inflation rate keeps rising, RBI may raise the ‘repo rate’, the short term rate at which banks park excess funds with the RBI. This makes it less attractive for banks to lend. Further, RBI may raise the bank rate, the rate at which it lends to banks.

At this point you may expect interest rates on home loans and fixed deposits to go up as well. Over a year rates could go up by as much as 3 per cent.

Role of interest Income:
Conceptually, interest is the return to the capital as a factor of production. According to the traditional theory, interest is paid for abstaining from present consumption leading to savings. Savings is the basis of investment and capital formation. At the macro level, capital is a major factor of production to which interest is a reward or income just as wages, profits, rents, etc.

Inter-alia, investment is function of interest rate, and the quantum and directional flow of investment determine income. More significantly, the impact of interest rate is both on savings and investments in the economy. In other words, the borrowings as well as lending are influenced by the interest rate. The cost of production which depends on the production function also includes the credit costs, as credit is an input in the productive process.

The savings and investment in the economy which are influenced by the interest rates are the real economic variables. The income and expenditure of the various sectors of the economy result in excess savings or excess investments in each of the sectors. The sector having excess savings provide them to those with excess investment. It is these savings and investment activities of the real sector which are influenced and facilitated by the flow of funds from the financial system. Here both domestics as well as international forces operate if the economies are open.

Role of Interest Rates:
Interest rates has diverse roles in the economy such as a reward to capital which is a factor of production, a return to saving and a cost to investment and an instrument of monetary policy for credit control. The role of interest rate mechanism in India has been the subject of controversy. In fact, even in theory there has been a controversy from the days of LORD KEYNES about the role of interest rates in the economy. In this background, it is relevant to examine the role of interest rates in India. Do interest rates influence mobilisation of savings? How far interest rates influence deposits of bank and shifts as between deposits of various maturities? These and other aspects of interest rates are relevant for policy makers.

At the macro level interest is the reward to the capital which is a factor of production. In the developing economy, capital formation and capital accumulation are of vital importance to economic development. Interest rates influence both savings and investment in the economy and serve a vital role for the mobilization of savings. Thus, in addition to influencing their cost, and availability of funds from the supply side, interest rates also influence the quantum of investment from the demand side and thus determine the income and employment within the economy.

Interest rates have also a significant role in the investment process in India. Our empirical tests have shown that the domestic capital formation in India is a function of GDP, MEC@ and the cost of capital.

Factors influencing interest rates:
Saving flow into various physical and financial assets. Financial assets are future claims on money like bank deposits, UTI units, shares, debentures, etc. These are in the form of I.O.U.s. These financial assets have a structure of interest rates which should be rationally based on the degree of risk of ownership, uncertainty of return, period of maturity and a host of other factors.

The factors which influence interest rates on various financial investments are the nature of the instrument, maturity period, risk, tax status, marketability and liquidity. These are as discussed below:
1. The return on ownership capital should be higher than on loan capital, as the risk of the former is greater than that of the latter.
2. Difference in maturity period would influence the extent of risk taken during the period when the lender is out of funds for varying periods of time. Ordinarily, the longer the period, the higher is the interest rate.
3. The degree of default risks or uncertainty of returns would also determine the interest rates. Such risks are nill or negligible in the case of government bonds while they are higher in the case of private debt or private ownership securities or company deposits. The rate is to be higher on those which have the higher risk.
4. The tax provision on the financial instruments or incentives or disincentives in the form of taxes on interest income or tax concession would also influence the demand for different type of financial assets. Thus, the effective rates on some postal certificates are higher due to tax concessions which would increase the effective take home rates.
5. Another factor is the marketability of the financial instruments with facilities for discounting or re-discounting and/or ready saleability which thus imparts liquidity and/or ready saleability which in turns give liquidity to instruments. Liquidity means convertibility of assets into cash as and when required without loss of time or money.
6. Safety of funds is another factor and is reflected in the credit worthiness of the borrower and expected return flow of principal and interest money.

There are drawbacks inherent in any system of partially controlled market force with some rates fixed by government, some rates by Reserve Bank and few left to the market forces. The multiplicity of controls and the agencies controlling have made the interest rate system in India complicated and distorted. This complex system prevailing even in the organized markets is made more difficult to comprehend by the generally uncontrollable interest rates charged in the unorganized and primitive markets in India.

Structure of Interest Rates:
Leaving aside the time factor, the increase in risk in respect of banks’ lending rates and then longer period involved in such lending have been reflected in the higher level of interest rates on them. As compared with the call money rates or T-Bills rates, which are for short periods, the interest rates on debenture, PSU bonds and term-lending rates by bank are higher due to higher risk involved. Thus risk maturity period, the safety and certainty of funds, etc would influence the relative levels of interest rates and the structure of rates.

There are various types of instruments with varying rates of interest in India. These rates will depend on the characteristics of these instruments like ownership risk, variability of return, maturity period, safety, marketability, etc. The data clearly brings out the upward and downward shifts in the structure of rates depending upon the level of risk. Time period of maturity and other features of the financial instruments involved.

In India, some of these interest rates are fixed by the government. The bank deposits and lending rates and those of financial institutions are fixed by the RBI, while the rates on P.O instruments, PSU bonds and those on governments’ securities are all fixed by the government in consultation with RBI.

The rational of regulating interest rates in india is as follows:
1. It keeps the interest costs low for the government Borrowings and their investments.
2. It promotes the socio-economic objectives of providing cheaper finance to weaker sections and priority sectors of the economy.

Theories of the Interest rate structure:
The Expectations Hypothesis: The simplest theory of the term structure is the Expectations Hypothesis a common version of this hypothesis states that the forward rates equals the market consensus expectations of the further short interest rate; in other words, that f2 = E(r2) and that liquidity premiums are Zero. Because we may relate yields on long term bonds to expectations of future interest rates. In addition we can use the forward rates derived from the yield curve to infer market expectations of further short rates. If the expectation hypothesis is correct. The yield to maturity would thus be determined solely by current and expected future one period interest rates. An upward sloping yield curve would be clear evidence that investors that investors anticipate increase in interest rates.

Liquidity preference Theory: The short term investors will be unwillingly to hold long term interest bonds unless the forward rate exceeds the expected short interest rate. Whereas long term investors will be unwillingly to hold short bonds unless. In other words both groups of investors require a premium to induce them to hold bonds with maturities different from their investment horizons. Advocates of the liquidity preference theory of the term structure believe that Short-Term investors dominate the market so that, generally speaking, the forward rate exceeds the expected short rates. The excess of f2 over E (r2), the liquidity premium is predicted to be positive.

Market segmentation and preferred habitat Theories: Both the liquidity premium and expectations hypothesis of the term structure implicitly view bonds of different maturities as potential substitutes for each other. An investor considering holding bonds of one maturity possibly can be lured instead into holding bonds of another maturity by the prospect of earning a risk premium. In this sense markets for bonds of all maturities are inextricably linked and yields on short and long bonds are determined jointly in market equilibrium.

Market segmentation Theory holds the long and short maturity bonds are traded in essentially distinct or segmented markets, each of which finds its own equilibrium independently. The activities of long term borrowers and lenders determine rates on long term bonds. Similarly short term traders set short rates independently of long term expectations. The term structure of interest rates, in this view is determined by the equilibrium rates set in the various maturity markets.

The view of market is not common today. Both borrowers and lenders seem to compare long and short rates, as well as expectations of future rates, before deciding whether to borrow or lend long or short term. That they make these comparisons, and are willing to move in a particular maturity if it seems sufficiently profitable to do so, means that bonds of all maturities compete each other for investors attention. Which implies that the rate on a bond of any given maturity is determined with an eye towards rates on competing bonds, this view of the market is known as preferred habitat theory.

Conclusion:
What might one conclude from the observation that longer-term bonds usually offer higher yields to maturity? One possibility is that longer-term bonds are riskier and that the higher yields are evidence of a risk premium that compensates for interest rate risk. Another possibility is that at these times investors expect interest rates to rise and that the higher average age yields on long-term bonds reflect the anticipation of high interest rates in the latter year of the bond’s life. We start our analysis of these possibilities with the easiest case: a world with no uncertainty where investors already know the path of future interest rates.

The rates are under the direct control of the government so that the factious growth can be achieved and the direct role in influencing the directory power can be adjudged further the role empowering the role and growth of it judging the nature and power can be seen and deciding the role further empowering the growth of economy and other future perceptive to it.

Annexure:
Structure of Interest Rate in India

# The functions tried to approximate one of the three role function of term structure relevant at time of rational expectations the rational expectations hypothesis was the most popularly assumed.
# A 10 Paisa difference with a bond worth Rs. 80 is a worse fit than for which is worth Rs. 105.
# The net present value of all cash flows discounted to the present is called the Dirty Price.
# A repo or repurchase Agreement is an instrument of money market. Usually reserve bank (federal bank in U.S) and commercial banks involve in repo transactions but not restricted to these two. Individuals, banks, financial institutes can also participate in repurchase agreement.
# Indian banks are required to hold a certain proportion of their deposits as cash. In reality they don’t hold these as cash with themselves, but with Reserve Bank of India (RBI), which is as good as holding cash. This ratio (what part of the total deposits is to be held as cash) is stipulated by the RBI and is known as the CRR, the cash reserve ratio
# The hike in CRR is not likely to lead to an immediate increase in interest rates. There is excess liquidity in the system even after a higher amount is deposited with RBI as reserves.
# The savings and investment in the economy which are influenced by the interest rates are the real economic variables. The income and expenditure of the various sectors of the economy result in excess savings or excess investments in each of the sectors.
# LORD KEYNES about the role of interest rates in the economy. In this background, it is relevant to examine the role of interest rates in India.
This complex system prevailing even in the organized markets is made more difficult to comprehend by the generally uncontrollable interest rates charged in the unorganized and primitive markets in India
# The simplest theory of the term structure is the Expectations Hypothesis a common version of this hypothesis states that the forward rates equals the market consensus expectations of the further short interest rate; in other words, that f2 = E(r2)
# The yield to maturity would thus be determined solely by current and expected future one period interest rates.
# Both the liquidity premium and expectations hypothesis of the term structure implicitly view bonds of different maturities as potential substitutes for each other.

The  author can be reached at: prateeksharma@legalserviceindia.com

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