Interest Rates Essay Example For Students

Interest Rates Essay Interest rate essay Causes ofcan be explained as -deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. Alternative investments. The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds. Risks of investment. There is always a risk that the borrower will default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss. The nominal interest rate is the amount, in money terms, of interest payable. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. There is a market for investments which ultimately includes the money market, bond market, and stock market and currency market as well as retail financial institutions. The CAPM returns the asset-appropriate required return or discount rate i.e. the rate at which future cash flows produced by the asset should be discounted given that assets relative riskiness. Betas exceeding one signify more than average riskiness; betas below one indicate lower than average. Thus a more risky stock will have a hi gher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition investors (should) require a higher return for holding a more risky asset. Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market. The risk of a portfolio is comprised of systematic risk and specific risk. Systematic risk refers to the risk common to all securities i.e. market risk. Specific risk is the risk associated with individual assets. Specific risk can be diversified away (specific risks average out); systematic risk (within one market) cannot. Depending on the market, a portfolio of approximately 15 (or more) well selected shares might be sufficiently diversified to leave the portfolio exposed to systematic risk only. A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context i.e. its contribution to overall portfolio riskiness as opposed to its stand alone riskiness. In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:?The risk-free cost of capital ?Inflationary expectations ?The level of risk in the investment ?The costs of the transaction The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-free, bills issued by major nations like the United States are generally regarded as risk-free benchmarks. The Accident That Changed My Life EssayIt is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may under-react. All that is required by the EMH is that investors reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable. Or in other terms, an efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its fundamental value. There are three forms of the efficient market hypothesis 1.The Weak form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use. 2.The Semi-strong form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use. 3.The Strong form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. Securities markets are flooded with thousands of intelligent, well-paid, and well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be.