Since the interest rate is the price of the earlier availability of dollars, a change in the interest rate means that this price has changed. For example, if the interest rate rises from a level of 10 percent to 12 percent, the price (or value of present dollars rises in terms of future dollars.
Before the change in the interest rate, borrowing a dollar today necessarily meant giving up 1.10 dollars one year from now or 1.21 dollars two years from now, etc. After the increase in the interest rate, borrowing a dollar today requires the sacrifice of 1.12 dollars one year from now or 1.25 dollars two years from now, etc. Since financial instruments represent claims to dollars at different points in the future, changes in the interest rate affect the relative values of financial assets and liabilities.
A rise in the interest rate has two important effects on financial claims. First, it reduces the present value of all such instruments in terms of present dollars. Second, and equally important, the present values of various instruments will change in terms of each other; the prices of claims to dollars in the more distant future will fall relative to the prices of claims to dollars in the near future.
The shares and debt instruments are alternative ways of investment. If the interest rates on debt instruments fall, shares become more attractive to buy.’ demand for shares increases, their prices rise too, and so the dividend return gained from them fall” percentage terms. If interest rates went up, the shareholder would probably want a higher return from• his shares and share prices would fall.
Term Structure and Interest Rates – The most commonly quoted interest rates in the financial markets are:
- The bank’s base rate
- The inter-bank lending rate
- The treasury bill rate
- The yield on long- dated gilt-edged securities.
The term structure of interest rates describes the relationship between interest rates and loan maturities. The maturity pattern of debt is an important factor for interest rate determination. The maturity pattern is particularly relevant in the gilt-edged market, small savings schemes and deposit and lending rates of banks. The longer the maturity, the larger is the risk and hence the risk premium.
The interest rates on debentures, PSU bonds and term lending rates by banks are higher due to high risk involved. These rates depend on the characteristics of these instruments like ownership risk, variability of return, maturity period, safety, marketability etc. Therefore the upward and downward shifts in the structure of rates depends upon the level of risk, time period of maturity and other features of the financial instruments involved.
