Saturday, October 27, 2007

Interest rates

When the Central Bank(RBI) meets to decide on interest rates,it has significant effect on the stock markets.

When the Central Bank(RBI) is expected to bring interest rate cuts or increases,it is wise, as a stock investor, to be aware of the potential effects behind such decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions.

A decrease in interest rates means that those people who want to borrow money enjoy an interest rate cut.

But this also means that those who are lending money, or buying securities such as bonds, have a decreased opportunity to make income from interest.

If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market.

At the same time, businesses will enjoy the ability to finance expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices. Investors and economists alike view lower interest rates as catalysts for expansion.

The unifying effect of an interest rate cut is the psychological effect it has on investors and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.

Forces Behind Interest Rates
An interest rate is the cost of borrowing is the compensation for the service and risk of lending money.

Lenders and Borrowers
The lender of money is taking a risk that the borrower may not payback the loan. Thus, interest provides also a certain compensation for bearing risk.

Coupled with the risk of default is the risk of inflation. When you lend money now, the prices of goods and services may go up by the time you are paid back your money, whose original purchasing power would have decreased. Thus, interest protects against future rises in inflation. A lender such as a bank uses the interest to process account costs as well.

The borrowers pay interest because they must pay a price for gaining the ability to spend now as opposed to having to wait years and years to save up enough money.

Interest can thus be considered a cost for one entity and income for another. Interest is the opportunity cost of keeping your money as cash under your mattress as opposed to lending. If you borrow money, then the interest you have to pay is less than the cost of forgoing the opportunity to have the money in the present.

How Interest Rates Are Determined

Supply and Demand
Interest rate levels are a factor of the supply and demand of credit(for = home loans,vehicle loans), an increase in the demand for credit(loans) will raise interest rates, while a decrease in the demand for credit will decrease them.

Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.

The supply of credit(loans) is increased by an increase in the amount of money made available to borrowers.

For example, when you open a bank account, you are actually lending money to the bank.Depending on the kind of account you open , the bank can use that money for its business and investment activities.

In other,words the bank can lend out that money to other customers. The more banks can lend, the more credit(loans) is available to the economy. And as the supply of credit(loans) increases, the price of borrowing (interest) decreases.

Inflation will also affect interest rate levels. The higher the rate of inflation, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future.

The government has a say in how interest rates are affected. The Central banks (the US Fed or RBI) often comes with out announcements about how monetary policy will affect interest rates.

The Central banks(Call or money market) rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend; the rate then eventually trickles down into other short-term lending rates.

When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates then decrease. When the government sells securities, money from the banks is drained for the transaction, rendering less funds at the banks' disposal for lending, forcing a rise in interest rates.

As interest rates are a major factor of the income you can earn by lending money, of bond pricing,and of the amount you will have to pay to borrow money, it is important you understand how prevailing interest rates change: primarily by the forces of supply and demand, which are also affected by inflation and monetary policy.

Excerpts,contents Re-edited by me and with contents courtesy-Investopedia
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