MARKET INTEREST RATES

AND
ITS IMPLICATIONS
ON
INVESTMENT DECISIONS
Table of Contents pg no.
What is Interest?..................................................................................3
Market Interest Rate…………………………………………………3
Determination of Market Interest Rate………………………………3
Components of Market Interest Rate………………………………...4
Implications of Market Interest Rates………………………………..5
Interest Rate and Risk…………………………………………5
Interest Rate and Bonds……………………………………….6
Interest Rate and Common Stock……………………………...7
Interest Rate and Foreign Exchange………………………….8
Interest Rate and Banks……………………………………….8

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 MARKET INTEREST RATES
AND
ITS IMPLICATIONS
ON
INVESTMENT DECISIONS
What is Interest?
Interest can be explained from viewpoints of two people: borrower and
lender:
Borrower: Cost of money for borrowing loan.
Lender: Price of money for lending a loan.

Market Interest Rate

Rates of interest paid on deposits and other investments, determined by the
interaction of the supply of and demand for funds in the money market is
called the market interest rate.

Determination of Market Interest Rates

Interest rates are determined by the interaction of the quantity supplied and
the quantity demanded of money. The quantity supplied of money is

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determined by the actions of the central bank and the banking system.
Suppose that the interest rate is too high in the sense that the quantity of
money supplied is greater than the quantity of money demanded. People will
respond by purchasing bonds, in which case money will be reduced. The
greater demand for bonds will push interest rates down, towards equilibrium.

Components of Market Interest Rate

Quoted interest rate = k + k* + IP + DRP + LP + MRP
Here
k = the quoted, or nominal, rate of interest on a given security. There are
many different securities, hence many different quoted interest rates.
k* = the real risk-free rate of interest. k* is pronounced “k-star,” and it is the
rate that would exist on a riskless security if zero inflation were expected.
IP = inflation premium. IP is equal to the average expected inflation rate
over the life of the security. The expected future inflation rate is not
necessarily equal to the current inflation rate, so IP is not necessarily equal
to current inflation.
DRP = default risk premium. This premium reflects the possibility that the
issuer will not pay interest or principal at the stated time and in the stated
amount. DRP is zero for some securities, but it rises as the riskiness of
issuers increases.
LP = liquidity, or marketability, premium. This is a premium charged by
lenders to reflect the fact that some securities cannot be converted to cash on
short notice at a “reasonable” price. LP is very low for some securities and
for securities issued by large, strong firms, but it is relatively high on
securities issued by very small firms.
MRP = maturity risk premium. Longer-term bonds, even Treasury bonds, are
exposed to a significant risk of price declines, and a maturity risk premium
is charged by lenders to reflect this risk.

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IMPLICATIONS OF MARKET
INTEREST RATES
Interest Rate and Risk
The main implication of market interest rate on investment is that the
varying interest rates are a risk for investment. The variability in a security’s
return resulting from changes in the level of interest rates is referred to as
interest rate. Such changes generally affect securities inversely; that is, other
things being equal, security prices move inversely to interest rates. Interest
rate risk affects bonds more directly than common stocks, but it affects both
and is a very important consideration for most investor. Interest rate risk is a
systematic risk and is unavoidable.
Bond prices are obviously interest rate sensitive. If rates rise, then the
present value of a bond will fall sharply. This can also be thought of in terms
of market rates: if interest rates rise, then the price of a bond will have to fall
for the yield to match the new market rates.
The longer the duration of a bond the more sensitive it will be to movements
in interest rates.
Shares are also sensitive to interest rates, again it is obvious that if interest
rates change (and other things remain equal, which the Fisher effect suggests
may not be the case) then DCF valuations will fall. In addition, the profits of
highly geared companies will be significantly affected by the level of their
interest payments.
Banks can also have significant interest rate risk: for example they may have
depositors locked into fixed rates and borrowers on floating rates or vice
versa.

Other Effect of an Increase in Market Interest Rates.

1. Cost of Borrowing is more expensive. If borrowing is more expensive

consumers will take out fewer loans. Firms will borrow less. Therefore
consumer spending and investment will fall (or increase at slower rates).

2. Mortgage and loan repayments increase. Higher mortgage payments

reduce disposable income so consumer spending will be lower.

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3. Return on savings increase. Saving is more attractive, so this will also
reduce consumer spending.

Bonds and Interest Rate

The price of a typical bond changes inversely to changes in interest rates or
yields. In other words, when interest rates increase, bond prices fall and vice
versa. Since bond prices fluctuate relative to interest rates, among other
things, bond investors would be wise to incorporate interest rate risks into
their portfolios’ performance measurements.
Bond prices are influenced by the yield they pay and the rate of interest
investors can earn elsewhere. If interest rates are high, savings accounts will
pay more and bonds, therefore, become less attractive.

Bond Features Impacting Interest Rate Fluctuations

How sensitive a bond’s price is to interest rate fluctuations depends on
certain characteristics of the bond, such as maturity, coupon rate and
existence of embedded options.
Maturity: The longer the bond’s maturity, the greater the bond’s price
sensitivity to interest rate fluctuations.
Coupon rate: The lower the coupon rate, the greater the bond’s price
sensitivity to changes in interest rates. The price sensitivity of Zero-coupon
bonds is the greatest when compared to coupon-bearing bonds of the same
maturity and trading at the same yield.
Embedded options: If a bond is callable prior to its maturity date at the
discretion of an issuer, this bond has an embedded option. But this particular
option is not favorable to an investor because if interest rates decline, the
issuer may find it beneficial to call the bond prior to its maturity date in
order to refinance the debt issue at lower interest rates, even if it means
paying a higher price. Unfortunately, the investor has no say in this, and
therein lays the interest rate risk associated with a bond with embedded
options.

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Stock and Stock Exchange and Interest Rates
Rising and falling interest rates offer a special risk to stock investors.
Historically, rising interest rates have had an adverse effect on stock prices
which has resulted in lower stock index. During 2008, the LSE-25 index
declined by 20% on a year-on-year basis due to higher inflation and higher
interest rates. Rising interest rates have a negative impact on companies that
carry a large current debt load or that need to take on more debt because
when interest rates rise, the cost of borrowing money rises, too. Ultimately,
the company’s profitability and ability to grow are reduced. When a
company’s profits (or earnings) drop, its stock becomes less desirable, and
its stock price falls.
The financial health of the customers directly affects the company’s ability
to grow sales and earnings. High or rising interest rates can have a negative
impact on any investor’s total financial picture. An investor has also to
struggle with burdensome debt, such as a second mortgage, credit card debt,
or margin debt. He may sell some stock in order to pay off some of his high-
interest debt. Selling stock to service debt is a common practice that, when
taken collectively, can hurt stock prices. So, stock is also affected indirectly
by the interest rates changes.
Futhermore, higher interest rates make it relatively more attractive to save in
banks rather than invest in the stock market.
Shares usually have an inverse relation with interest rates changes. But for
those industries that benefit from high interest rates have a positive relation
with interest rates like that of banks. Banks usually profit from high interest
rates. So, price of their shares grow when interest rates are high.

Impacting investors’ decision-making considerations

When interest rates rise, investors start to rethink their investment strategies,
resulting in one of two outcomes:
o Investors may sell any shares in interest-sensitive stocks that they
hold. Interest-sensitive industries include electric utilities, real estate,
and the financial sector. Although increased interest rates can hurt
these sectors, the reverse is also generally true: Falling interest rates
boost the same industries. Interest rate changes affect some industries
more than others.

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 o Investors who favor increased current income (versus waiting for the
investment to grow in value to sell for a gain later on) are definitely
attracted to investment vehicles that offer a higher rate of return.
Higher interest rates can cause investors to switch from stocks to
bonds or bank certificates of deposit.
Sometimes there is a little move in share prices when, for example, interest
rates shift. This is because investors try to anticipate what is going to happen
in the next few months and try to move their portfolios in or out of these
stocks before the rest of the market catches on. But most of the times, of
course, these expectations can be wrong and if this happen, markets can
move very sharply.

Foreign Exchange Rate and the Interest Rates

An increase in interest rates makes a currency more attractive. This causes
hot money flows into an economy causing an appreciation. Similarly a cut in
interest rates will often cause depreciation in the currency.

Banks and Interest Rates

Banks usually profit from high interest rate. However, changes in interest
rates affect a bank's earnings by changing its net interest income and the
level of other interest sensitive income and operating expenses. Changes in
interest rates also affect the underlying value of the bank's assets, liabilities
and off-balance sheet instruments because the present value of future cash
flows (and in some cases, the cash flows themselves) change when interest
rates change. Accordingly, an effective risk management process that
maintains interest rate risk within prudent levels is essential to the safety and
soundness of banks.
Banks face four types of interest rate risk:
Basis risk
The risk presented when yields on assets and costs on liabilities are based on
different bases, such as the base rate provided by SBP versus the Pakistan
market interest rate. In some circumstances different bases will move at
different rates or in different directions, which can cause erratic changes in
revenues and expenses.

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Yield curve risk
The risk presented by differences between short-term and long-term interest
rates. Short-term rates are normally lower than long-term rates, and banks
earn profits by borrowing short-term money (at lower rates) and investing in
long-term assets (at higher rates). But the relationship between short-term
and long-term rates can shift quickly and dramatically, which can cause
erratic changes in revenues and expenses.

Repricing risk
The risk presented by assets and liabilities that reprice at different times and
rates. For instance, a loan with a variable rate will generate more interest
income when rates rise and less interest income when rates fall. If the loan is
funded with fixed rated deposits, the bank's interest margin will fluctuate.

Option risk
It is presented by optionality that is embedded in some assets and liabilities.
For instance, mortgage loans present significant option risk due to
prepayment speeds that change dramatically when interest rates rise and fall.
Falling interest rates will cause many borrowers to refinance and repay their
loans, leaving the bank with uninvested cash when interest rates have
declined. Alternately, rising interest rates cause mortgage borrowers to repay
slower, leaving the bank with relatively more loans based on prior, lower
interest rates. Option risk is difficult to measure and control.

Hedging Interest Rate Risk

Interest rate risk can be hedged using swaps and interest rate based
derivatives.
Ways in which interest rate risk can be controlled include:
1. investment in floating rate rather than fixed rate securities
2. investing only in securities due to mature in the short term
3. buying interest rate derivatives.

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Calculating Interest Rate
There are a number of standard calculations for measuring the impact of
changing interest rates on a portfolio consisting of various assets and
liabilities. The most common techniques include:

1. Marking to market, calculating the net market value of the assets and
liabilities, sometimes called the “market value of portfolio equity”
2. Stress testing this market value by shifting the yield curve in a specific
way. Duration is a stress test where the yield curve shift is parallel
3. Calculating the Value at Risk of the portfolio
4. Calculating the multiperiod cash flow or financial accrual income and
expense for N periods forward in a deterministic set of future yield
curves
5. Doing step 4 with random yield curve movements and measuring the
probability distribution of cash flows and financial accrual income
over time.
6. Measuring the mismatch of the interest sensitivity gap of assets and
liabilities, by classifying each asset and liability by the timing of
interest rate reset or maturity, whichever comes first.

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