## The Basics of Interest Rates

The cost of money is the opportunity cost of holding cash instead of investing it, depending on the interest rate. An interest rate is the rate at which a borrower pays interest for using money that they borrow from a lender. Market interest rates are driven mainly by inflationary expectations, alternative investments, risk of investment, and liquidity preference. The term structure of interest rates describes how interest rates change over time.

### Drivers of Market Interest Rates

Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.

#### LEARNING OBJECTIVE

• Calculate the nominal interest rate of a given investment

#### KEY POINTS

• A market interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
• Economists generally agree that the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the costs of the transaction.
• A basic interest rate pricing model for an asset is presented by the following formula: $i_n = i_r + p_e + r_p + l_p$.

#### TERMS

• inflation

An increase in the general level of prices or in the cost of living.

• abscond

To flee; to withdraw from.

• liquidity

Availability of cash over short term: ability to service short-term debt.

• interest rate risk

the potential for loss that arises for bond owners from fluctuating interest rates

A market interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.

#### Factors Influencing Market Interest Rates

Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. According to the time preference theory, people prefer goods now to goods later. In a free market, there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. If the inflationary expectation goes up, then so does the market interest rate and vice versa.

Worldwide Inflation Rates 2009: World map showing inflation rate by country.

Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, boosting the market interest rate up.

Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. The greater the risk is, the higher the market interest rate will get.

Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. If people are willing to hold more money in hands for convenience, the money supply will contract, increasing the market interest rate.

#### Market Impact

There is a market for investments that ultimately includes the money market, bond market, stock market, and currency market as well as retail financial institutions like banks. Exactly how these markets function is sometimes complicated. However, economists generally agree that the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the costs of the transaction. This rate incorporates the deferred consumption and alternative investments elements of interest. A basic interest rate pricing model for an asset is presented by the following formula: $i_n = i_r + p_e + rp + lp$.

Assuming perfect information, $p_e$ is the same for all participants in the market, and this is identical to: $i_n = i^*_n+ rp + lp$

where $i_n$ is the nominal interest rate on a given investment, $i_r$ is the risk-free return to capital, $p_e$ = inflationary expectations, $i^*_n$ = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills), $rp$ = a risk premium reflecting the length of the investment and the likelihood the borrower will default, $lp$ = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).