Question

Chapter 5 Summary Questions-You should answer these questions as a summary for the chapter and to help you study for the exam. • How are interest rates determined? o What factors affect interest rates? o What is the term structure of interest rates? What are the theories that have been developed that help explain the shape of the yield curve? o Describe how interest rates can be forecasted. Why is it important to understand how interest rates are determined?

Answer 1

1. Interest rates of every country depend upon each country's central bank for example Bank of England, RBI, Unions States Federal Reserve Bank, etc. It is determined by social, political and economic reasons. They are calculated every year and on the basis of these, financial institutions can raise their interest rates for various purposes.

2. Factors which affect interest rates are: -

• Demand - Higher the demand, the higher the interest rate.
• Supply - If the supply of money increases, then interest rates will go down.
• Inflation - Higher the inflation, the interest rates will stay up.
• Bank Rate - Higher the bank rate, higher the interest rate.

3. Term Structure of interest rates - It is also known as yield curve when plotted on the graph the bonds against their maturities. It is important because it tells about the economic position of a country. If there is a steep positive curve then the future investors expect strong future economic growth, when there is a flat curve then investors are not sure about the economic growth of the country in the future, and when, there is an inverted curve then the investors expect sluggish economic growth.

Theories: - There are three theories that explain the shape of the yield curve. They are as follows:

• Expectations Theory - It is used to predict the future short term interest rates based on current long term interest rates.
• Liquidity Preference Theory - This theory suggests investors should demand a high-interest rate which has long term maturities with high risk.
• Segmented Market Theory - This theory depicts that the markets or bonds operate independently. Every bond has its own forces of demand and supply and length of maturities.

4. The interest rates are forecasted using predictive financial analysis. It's difficult to calculate the interest rates because a lot of changes happen in an economy and different factors on which interest rates depend get change timely. But interest rates can be constructed from the price of bonds (market). There are two methods of this (i) Rates Adjustment Method (ii) Probability Adjustment Method.

5. It is important to understand the determination of the interest rates because it will tell us about the position of the country and economic growth. Therefore, we can make wise financial decisions on the basis of this.