FinancialMarket and Institutions
FactsAbout Interest Rates
Interestrates are the costs charged by a financial institution to theborrowing for lending them the money for investment. As the borrowertakes the money from the financial institution, they are expected torepay this amount to the institution plus some profit they have gotfrom using the money. in this prospect, the borrower would view thisas the cost of borrowing. In most cases, the interest rates usuallyfluctuate from time to time with keen attention drawn to the factthat they are affect by the forces of demand and supply of theinvestment.
Oneof the fundamental roles of the government is to makes sure thatthere us stability in the interest rates. Many financial institutionshave been regulated on the interest rates with which they offer theirloans. This regulation is done the central bank of ever country. Thecentral bank is charged with the mandate of ensuring that they usethe monetary policies in creating a good environment for economicgrowth. In this prospect, they tend to give much attention to thenotion of controlling the interest rates. Some of the reasons why thecentral bank regulate the interest rates is because they want toprotect the lives of the common citizens from economic shock and toenhance the level of investment in the country.
Oneof the roles of interest rates in the valuation is that they are usedas discounting factor in discovering the real value of an asset orinvestment. for example, when one wants to invest in real estate,they have to know the cost of borrowing as represented by the lendinginterest rates of the banks. The investor must also know the interestrate of returns that they would get in the long end. To get a profitout of their investment, the lending rate must be less than therequired rate of return. Interest rate do change due to forces ofdemand and supply of money in the economy.
Presentvalue of an investment is the current value of the investment gotthrough discounting the future cash flows from the investment usingthe required rate of return. The formula is (future value of cashflows/present value interest factor) The concept of present value canbe applied to four areas. simple loan, fixed payment loan, couponbond and discount bond.
FactsAbout Loan and Present Value
Principalamount the initial amount to the given to the borrower by thelender. Interest payments are the amounts paid to the borrower on topof the principal amount. In simple loans you pay loan principal plusthe interest in one lump sum.
Fixedpayment loans you pay a fixed amount to repay the loan plus theinterest in equal measure until the loan is cleared. The formula forpresent value of an investment is as follows
Thefuture value of an investment is as shown below
Thepresent value of annuities is as shown below
Realinterest rate is the prevailing market interest rate after thededuction of the inflation rate factor while nominal interest isinclusive of the inflation factor.
Interestrate risks is the volatility of returns due to changes in theinterest rates that create high level of risks to the valuation ofthe firm.
Thereare tools of monetary policy that the government through the centralbanks use to regulate the supply of money. These are the open marketoperations where the central bank sells the securities and bonds onbehalf of the government in times of high money supply. When theysell these securities, the amount of money supply reduces hencecreating a contractionary measure. When there is less amount of moneyin the country then the government would buy these bonds and increasethe quantity of money supply in the country.
Anothertool of monetary policy is the controlling of the interbank rates.This notion entails changing the rate at which the banks can lend tothe public hence controlling them. Another monetary tool is thecontrol of the reserve for the banks. To reduce the amount incirculation, the central bank would increase the reserve requirementsfor the banks which makes them unable to lend.
Anothertool of monetary policy is the printing of new money in the economyto spur up investment. this move has the effect of creating highlevel of inflation which at time could be dangerous if notcontrolled.
Thefive goals of monetary policy are to create high employment, thestabilize financial markets, to stabilize the interest rates, tocreate stability in the forex market and to create a platform forhigh economic growth. Monetary targeting is a situation where thegovernment decides to commit to a persistent growth to a particularsector. For example, a target growth of M1 which the government isdeemed to be held accountable.
Conflictof interest is a situation where the shareholders and the managementdiffer in terms of main goals. The shareholder’s objective could beto maximize profits in the long run while the managers would want todo this in the short run.