Question

Identification: Identify the topic and explain why you believe the topic is important. the topic is Interest rates Explanation: Explain the calculations or concepts, and how it can be used in decision-making. Application: Assuming your audience knows nothing about the topic, explain how to apply it: As an entry-level professional. As a mid-level professional. As an executive-level professional. Ethics: Identify 1 ethical issue related to this topic and explain how you would address it.

Answer 1

Solution:-

Interest rates and their importance:

Interest rates is probably the single most important financial metric that's tracked and used by finance professionals in all walks of financial services. Interest rates refer to the rate at which central bank lends money to various banks in a country. The importance of interest rates stems from the following facts:

• All financial assets in an economy, including equities, bonds, real estate, etc. are valued based on the benchmark interest rates in the economy.
• Interest rates directly impact various macro economic factors.
• Interest rates determine the cost of borrowing for people in an economy, thus the cost of owning a house, car, business loans or pretty much anything else is directly dependent on the prevailing interest rates in the economy.
• The exchange rate between currencies of two currencies is directly influenced by the prevailing interest rates in the two economies

Role of interest rates in decision making:

Valuation of financial assets

In simple words, interest rates (also known as risk free rate) represent the risk free rate in an economy, i.e. the return an investor can made without taking any risk. Using this as the basis, the investors evaluate the risk in an asset and thus decide the required rate of return on their investments and thus they are valued in markets accordingly. Higher the interest rates in an economy, higher would be the required rate of returns on risky assets and vice-versa. As expected returns determine the valuation of assets, higher the interest rates lower the valuation of financial assets and lower the interest rates, lower the valuation of financial assets.

Thus, investors use interest rates to calculate the required return on their investments.

Macro economic decision making

In terms of macro economic factors, the prime examples are inflation and GDP growth. Low interest rates means cheap credit which pushes GDP growth higher and vice-versa. Similarly, low interest rates increases consumer spending and thus inflation goes higher and vice-versa.

Therefore, central banks use monetary policies to stimulate growth in an economy or control inflationary pressures. They do so by changing interest rates as the economic situation requires. If it wants to stimulate growth or push inflation higher, it would cut interest rates and vice-versa.

Capital decisions by financial managers

As shared above, interest rates determine the cost of capital for all businesses and thus all financial managers use them while making decisions to source of financing and optimal capital structures.

Application by professionals:

• Entry-level professionals would require to use interest rates to calculate the cost of capital of their businesses and to judge the appropriateness of various sources of debt funds available to the business
• Mid-level professionals use interest rates to determine the viability of a new project/business lines by forecasting the expected rate of returns on the projects and comparing it with the cost of capital of the business
• Executive-level professionals need to analyse interest rates to gauge the broader economic trends and thus prepare the mid to long-term strategic plans of expansion of their companies' business

Ethical issue related to interest rates:

Interest rates in an economy should be managed not just purely on financial basis, but it must be ensured by governments, central banks, planning commissions and financial institutions that the weaker sections of the society don't bear the burden of extremely high interest rates. For e.g.- the interest rates for business loans and farming loans shouldn't be same as farmers are more economically supressed. The governance should ensure that small businesses, farmers, and other weaker sections of the society should be able to avail loans at affordable rates of interest. Similarly, the interest rates for necessity based loans such as educational loans, affordable housing, etc. should be ethically kept at more affordable levels than other loans such as car loans, etc.