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INTEREST RATE | DOES IT AFFECT INVESTMENT? IF YES, HOW

Updated on January 9, 2011

Investments are affected by the movement of the governing cost of debt and cost of capital and this subsequently affects the share pick of the company. That is to answer in the affirmative. This then will lead us to ask the next question which is ‘how?’ To provide answer to this, we need to firstly explore interest rates and then find out how for our selves. Read on.

MEANING AND DEFINITION OF INTEREST RATE

Interest rates effectively are prices governing the ‘lending and borrowing’ activities of investors. The borrower pays the agreed or current rate to the lender for the period which finance has been used by the borrower. In the absence of other factors like other prices, the forces of supply and demand affect interest rate.

TYPES OF INTEREST RATES

  • Floating interest rate: floating interests rates are those cost of debt that changes according to the market condition. It comes with risks that affect investments. The good thing about the interest rates is that the possibility to cancel out the risks exists as corresponding liabilities for every asset. Companies create assets that will generate interest receivable for every interest payable. This process is known as interest rate risk hedging.
  • Fixed interest rate: this is a kind of interest whose interest is known from the beginning of the borrowing and lending process and remains so till the end of the contract regardless of the movement in interest rate. When interest rate goes up, one party looses and vice versa.

Interest rate swap can be used to manage any of the interest rate exposure that a company may be exposed to.

TYPES OF INTEREST RATE GAP EXPOSURE

Gap analysis is used to identify the level of exposure that a company is exposed to. Gap analysis is based on the principle of grouping together assets and liabilities that are sensitive to interest rate changes according to their maturing date. There are two kinds of interest rate gap exposure namely:

POSITIVE GAP

A positive gap occurs when a company has more interest sensitive asset than interest sensitive liabilities maturing at a certain time.

NEGATIVE GAP

A negative gap exists when there are more maturing liabilities prone to interest rate changes than there are assets.

PATTERN OF INTEREST RATES/ CAUSES OF INTEREST RATE FLUCTUATIONS

The pattern of interest rates is the phrase used to describe the variety of interest rate on different financial assets, and central banks margin on lending and deposit rate. In other words, the causes of interest rate fluctuations. The answers to the varying interest rates are provided below:

  • Risk
  • Need to make a profit
  • Size of the loan or deposit
  • Length of lending
  • Different types of financial asset

GENERAL LEVEL OF INTEREST RATES

There are situations when interests on a particular asset fluctuate. The reason for this fluctuation is referred to as general level of interest rates. Factors responsible for this are listed and briefly explained below.

  • Desire for real return
  • Effects of inflation
  • Uncertainty of potential inflation
  • Demand for borrowing and liquidity preference of investors
  • Balance of payments
  • Monetary policy
  • Interest rates oversees

EFFECTS OF MOVEMENT OF INTEREST RATE ON INVESTMENT AND INVESTING ACTIVITIES

Interest rate risk if not properly managed can turn an otherwise profitable business into a loss making business. Banks lending and borrowing rates can affect a business positively or negatively. When the spending powers of citizens are reduced by the prevailing interest rates, the sales level of companies and businesses drops, businesses will be exposed to economic exposure- i.e. standing the chance of making lose. Again, the cost of raw materials can either increase or decrease depending on the direction that interest rate is moving.

MANAGING INTEREST RATE RISK

  • Interest rate swap
  • Interest rate options
  • Interest rate futures contract
  • Matching and smoothing
  • Internal hedging- asset and liability management
  • Forward rate agreement

The above interest risk management tools are good to use but should be used with real care as they can result to more lose when misused. Consult with your professional risk managers who use asset allocation techniques when in doubt.

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