Interest rates are among the closely watched variables in the economy. The media on daily bases record their movement because they affect our everyday lives and have crucial consequences for the health of the economy. They affect personal decisions as whether to consume or save, whether to buy a house and whether to purchase bonds or put funds into a savings account. Interest rates also affect the economic decisions of households or businesses such as whether to put their money in the bank or invest in new equipments for factories.
Before continuing, we must understand exactly what interest rates mean. By holding financial instruments , such as loans or bonds. Savers and financial institutions extend credits to those individuals or firms that issue the instruments. The amount of credit extended is the principal amount of the loan or the bond. Those who hold financial instruments do so because they receive payments from the issuers in the form of interest. The percentage return earned is the interest rate or rate of return.
Rate of return is the price of credit in financial markets and is usually expressed as a percentage (%) of the total amount borrowed that is to be paid each year (over and above the repayment of the principal, or amount borrowed). Thus, it is the price of credit of the rate of exchange between the present and the future.
Rate of returns (r) vary given interest rate (i). It is the value of i that just equates the present value (PV) of the benefits of the extra capital when discounted at i to its cost (Pk). That is, r is defined as : r=MRP/Pk, where: MRP=Marginal Revenue Product
We would however, take a look at how interest rate is calculated, various theoretical analyses that seek to explain the determination of interest rates, distinctions between nominal and real interest rates. Finally, we shall relate it to the case of the Ghanaian economy and look at the consequences of the high interest rates in Ghana. CONCEPTS OF INTEREST YIELD/RATE
Interest yields on financial instruments are thought of in different ways. The most important of these are Nominal Yield
Yield to Maturity
Assuming that a bond is issued in an amount of 100,000 with an agreement to pay 6000 in interest every year. The annual payment of 6000 is the bond’s annual coupon return. This is simply the fixed amount of interest that the bond yields each year. The nominal yield on a bond is equal to rN= C/F, where rN is the nominal yield,
C is the coupon return and
F is the face amount of the bond.
The annual yield of the 100,000bond with the 6000 coupon yield or return is equal to 6000 / 1000,000=0.06 or 6 percent.
The current secondary market price of the bond typically is not the face value of the bond. Bonds often sell in the secondary market at prices that are different from their face value. For this reason, those contemplating on bond purchase often are interested in the current yield of a bond. This equals to r i =C/P
Where ri denotes the current market yield, C is the coupon return and P is the current market price of a bond. For instance, the current market price of a bond with a face value of 100,000 might be 90,000. If the coupon return on the bond is 6,000 per year, then annual current yield on this bond is equal to 6,000/90,000=0.667 or 6.7 percent.
Yield on Maturity
A bond’s yield on maturity is the rate of return if the bond is held until maturity. Calculating this yield can be complicated, however, because the bonds normally differ. Typically, bonds are sold at a discount, below its face value. Hence, other things being equal, the bond holder receives an automatic capital gain if the bond is held to maturity. A capital gain occurs when the value of a financial asset at the time it is redeemed or sold is higher than its market value when it was purchased. Consequently, the bond pays a...
Please join StudyMode to read the full document