INTEREST AND INTEREST RATE
1. What is Interest?
Interest can simply be defined as the cost of money. If an individual, a business or government uses someone else’s money, she/he/it must pay interest. In other words, an individual, business or government may use someone else’s money in return for interest. Interest can also be defined as the rent of money. Interest is also the required rate of return for the investment in debt securities and lending (lending can also bu considered as an investment). Lender charges interest in return for letting someone use her/his/its money, borrower pays interest in return for using someone else’s money. Interest is an income for the lender, a cost by the borrower.
Amount of interest is calculated as a percentage of the principal. Principal is the amount of money lent by the owner of the money and borrowed by the one who/which needs money. The percentage is called “interest rate”.
2. Components of Interest Rate
Nominal interest rate (also called stated interest rate) has several components. These components are explained below:
Real Risk Free Interest Rate: Real risk free interest rate is the pure rate that is charged for letting someone use someone else’s money. This rate does not include any risk premium. This rate exists when there is no inflation. This rate depends on people’s time preference for current versus future consumption. In other words, real risk free rate of interest is determined by the demand of funds by the deficit units and supply of funds by the surplus units.
If people do not want to spend now, they save money and supply more funds. When the supply of funds increase, the real risk free rate of interest decreases. When people prefer consumption now, they supply less funds and demand more funds, so the real risk free rate of interest increases.
The general level of risk aversion also affects the real risk free interest rate. If the general level of risk aversion increases lenders demand more interest, so the real risk free interest rate increases. If the general level of risk aversion decreases lenders demand less interest, so real risk free interest rate decreases.
Inflation Premium: Inflation is one of the important factors that has an impact on interest rates. Inflation reduces the purchasing power of money. Lenders want to preserve their purchasing powers so they demand inflation premium to compensate for the decrease of purchasing power as a result of inflation. Inflation premium is the expected rate of inflation over the life of the loan or debt securities (bonds and bills).
Nominal Risk Free Rate of Interest: Nominal risk free rate of interest is the real risk free interest rate plus inflation premium. This rate includes inflation risk (risk of decreasing purchasing power) but excludes other risks.
Default Risk Premium: Default risk premium compensates for the risk of not receiving the principal and the interest at maturity from the borrower. Default risk premium depends on the credibility of the borrower. If the credibility of the borrower is high, default risk premium is low. If the credibility of the borrower is low, default risk premium is high.
Maturity Risk Premium: Increase in interest rates is disadvantageous for the lenders, but advantageous for the borrowers. Suppose a person deposits money into a time deposit account in a bank when the interest rate is 10 %. If interest rate increases to 12 % during the maturity, the person cannot benefit from the new rate. Because she/he has to wait until maturity. As the maturity increases, so is the reprising time (as the maturity increases lender must wait longer to benefit from the increased interest rate). That is why as maturity increases lenders demand higher maturity risk premium to compensate for reprising risk (not benefiting from the higher interest rates).
Liquidity Premium: Liquidity premium is related to debt securities (bonds and bills). This concept is not related to the bank loans. When an investor buys bonds and bills from the primary market she/he can sell them in the secondary market before the maturity to convert them into cash. If a bond or bill can be sold in secondary market easily at a reasonable price it is liquid, otherwise it is illiquid. If the bond or bill is illiquid then the investors demand liquidity premium to compensate for the liquidity risk (not being able to sell the bonds and bills in the secondary market easily at a reasonable price).
Glossary:
Interest: Faiz
Interest rate: Faiz oranı
Principal: Ana para
Real risk free interest rate: Reel risksiz faiz oranı
Risk aversion: Riskten kaçınma
Inflation premium: Enflasyon primi
Nominal risk free rate of interest: Nominal risksiz faiz oanı
Default risk premium: Geri ödememe risk primi
Maturity premium: Vade primi
Liquidity premium: Likidite primi