Factors Affecting Interest Rates | Different Types of Interest Rate.
Certificate of Deposits
Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. The concerned bank issues a receipt that is both marketable and transferable in the market. The receipts are in bearer or registered form.
CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit. Basically, they are a part of the bank’s deposit; hence they are riskless in terms of payments and principal amount. CDs are interest-bearing, maturity-dated obligations of banks.
CDs benefit both the banker and the investor. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. This contributes to the liquidity and ready marketability of the instrument. CDs can be issued only by the scheduled banks.
The interest rate risk occurs due to the change in the unconditional level of interest rates which changes the investment’s values. These changes affect securities inversely but can be reduced by diversifying and hedging techniques.
Types of interest rate
1. Volatility risk – It refers to the risk occurring in the future price of the asset. The holder of an option experiences volatility of underlying assets based on the current market situation.
2. Rate level risk – It refers to the interest rates that fluctuate variably over a period of time. The probability of the change in the magnitude of interest rates varies according to the period of investments.
3. Reinvestment risk – It occurs when the interest earned from an investment does not provide the same rate of return during reinvestments. Hence there is a possibility to reinvest the cash flows at a lower rate of return.
4. Price risk – It refers to the risk occurring in the future due to the decline in the price of security like bonds or physical commodities.
5. Call/Put risk – During the appraisal of bonds, the funds include the call/put option. The two options experience risk during the fluctuations of interest rates. The call option usually works when there is a decline in the interest rate.
6. Real interest rate risk – It occurs due to the dissimilarity between the nominal changes of interest rates and changes in inflation. The inflation factors play an important role during the assessment of costs.
Sources of interest rate
1. Yield curve risk: The yield refers to the relationship between short-term and long-term interest rates. The yield curve risk occurs due to the yield curve fluctuations which affect the organization’s income and economic values of underlying assets.
2. Basis risk: Basis risk occurs due to the changes in the relationship between the various financial markets or financial instruments.
3. Optionality risk: Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs during the process of altering the bank’s instruments’ levels of cash flows by the bank’s customers or by the bank itself.
4. Repricing risk: Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of bank’s instruments such as assets, liabilities, and off-balance sheets.
5. Embedded option risk: The embedded option refers to other option securities such as bonds, financial instruments. The embedded option is a part of another instrument that cannot be separated.
Factors affecting the interest rates
1. Intensity of inflation – Inflation is defined as an increase in the typical price level of goods and services in an economy over a period of time. Inflation reduces the procuring power of a currency. So people with excess funds claim higher interest rates, as they want to protect their investment returns against the unfavorable conditions of higher inflation.
2. Fluctuation of monetary policy – The central bank of a country controls the money supply in the economy through its monetary policy. In India, the monetary policy of RBI focuses on price stability and economic growth. If RBI loosens its monetary policy then the interest rate gets reduced which leads to higher inflation. Whereas, if RBI strengthens its monetary policy then the interest rate increases, which thereby limits inflation.
3. Foreign exchange market activity – Foreign investor demand for debt securities influences the interest rate. Higher inflows of foreign capital lead to an increase in domestic money supply which in turn leads to higher liquidity and lower interest rates.
4. Property state – Varying property states have different regulations and requirements that result in fluctuating business costs. These costs are often passed to the consumer in the form of an interest rate for the lenders.
5. Budgetary deficit – Budgetary deficit and increased borrowing program of the Government will lead to an increase in interest rates as the demand for funds increases. With the increase in interest rates, costs go up and this will result in inflation.
Interest rate risk
Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond’s time to maturity, and the coupon rate of the bond.
Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible.
The Heath-Jarrow-Morton framework was developed in early 1991 by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University. There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities.