Question

What is the interest rate and how is it determined?

Answer 1

Interest rate is (typically expressed as percentage) the cost of borrowing. It is a percentage of the borrowed amount which is paid by the borrower (user of funds) to lender (provider of funds) as compensation for parting with money and for undertaking the risk of repayment . For examply A borrows $1000 from B for 1 year and in return promises to pay back $1000 plus a cost of borrowing. This cost of borrowing interest rate.

The interest rates are impacted by various factors like demand -supply, inflation, underlying risk, other alternative investment opportunities, time horizon, Central Bank policies and more. There are three key theories which explain the interest rate setting:

• Pure expectations theory : This theory states that interest rates across various periods are linked like 2 year rate is simply current 1 year rate and expected forward 1 year to 2 years rate. It postulates that investors can move across investment horizons such there will not be an arbitrage and interest rates will be function of each intervening period.
• Liquidity preference theory : this theory states that for longer tenures, the investors require higher risk premium hence the interest rates are going to be higher in longer terms than in shorter term since as the term increases the risk also increases
• Market segmentation theory : This states that investors have preference for specific time horizon buckets and demand supply in these buckets decide the interest rates. For an investor to move up or down the bucket, they will require incremental enticement to take risk and hence the interest rate levels will change accordingly