Interest Rates Structure,
determinants, development of BLR
and its computation
Definition:
a) the price of borrowing money
b) amount charged by lender to borrower for
borrowing a sum of money expressed as percentage
of sum borrowed
To a lender (surplus unit) – the return earned for
parting with his funds over a certain period of time
To a borrower (deficit unit) – the price to pay over a
specific period of time (the interest expense)
Nominal rate is the rate offered and quoted
to customers without taking into account the
inflation rate
Real rate is the rate after considering inflation
rate
Simple/Approximate formula:
Real Int. rate = Nominal Int. rate – Inflation rate
(NR) (IR)
Exact Formula:
Real interest rate = 1 + NR - 1
1 + IR
Simple Interest rates = pxrxn
365x100
where p = principal amount
r = nominal interest rate
n = no. of days
a. Describe the methods of calculating the
interest – example simple interest;
b. Describe the behavior of interest rate –
example fixed rate or variable rate (pegged
with BLR or KLIBOR)
c. Annual Percentage rate (APR)
Quotation based on applying an interest rate
to the daily loan balance outstanding during a
specified period;
Quoted in terms of annual rate (eg. 12 %) or
daily periodic rate (eg. 0.032877)
Fixed rate - only one interest rate quoted
through out the life of the loan
Same monthly payment
It is used because of stable income of
customers and easy to budget
However exposed banks to interest rate risk,
therefore use variable rate; how?
Variable rate or floating rates are rates pegged
against BLR, KLIBOR or multi-tiered rates
Rates changes with the pegged rates
Protect both borrower and lender against
fluctuations
Eg. When BLR increases, rates on variable loan
increases and is reflected in higher monthly
payments or increase in number of payment
Minimises interest rate risk but may increase credit
and collateral risk; how?
Sometimes banks quote both fixed and variable on
a particular loan
Gap between fixed and variable increases when
interest rates rise and narrow when rates drop
Fixed rates credit cards, car loan or other hire
purchase
Variable rates property-based lending and
business loans
Total cost of borrowing expressed as a percentage; common language to
describe cost of borrowing
Formula : 2NF (300C + NF)
2
2N F + 300C (N + 1)
Where N = number of instalments
C = no. of instalments to be paid in one year
F = amount determined by 100C x T
NxA
where T = total amount of predetermined term charges
N = no. of instalments
A = amount financed
BLR is a rate used by commercial banks and finance
companies as a basis to quote for lending and
advances facilities offered to customers
Generally, it is derived by taking into account the
funding cost. administrative cost and an imputed
profit margin
Previously, the funding cost is represented by the 3-month
KLIBOR average
later in 1998 in view of the economic situation the formula
was revised to be based on ‘intervention rate’
Old framework (for commercial bank):
BLR = (Average KLIBOR* x 0.8) + 2.5%
1 – SRR
* Intervention replaced KLIBOR in 1998
Currently each bank calculate its own BLR based on cost
structure and business strategies after considering the OPR
(more efficient pricing)
any changes in OPR will give impact to the level of BLR of
banks
BLR is based on Overnight Policy Rate (OPR) which
in turn is based on interbank rate
Thus, OPR is the primary reference rate in
determining other market rates
Interbank rates OPR
BLR
Lending rates
(Rates quoted to customers housing
loan/automobile loan/business loan)
Higher actual or expected inflation, higher
will be the level of interest rates (positive
relationship)
Investor needs to earn higher return to
compensate for the increased cost of
foregoing consumption of goods/services
today and buy more highly priced of these
goods/services in the future
The rate that would exist on a security
without any expected inflation over the
holding period
It is the percentage change in the buying
power of a dollar
It measures consumer’s relative time
preference for consuming today rather than
later ; the higher the preference to consume
today the higher will be the real interest rate
The risk that the issuer will not pay the
interest and principal on a timely basis
default risk the interest rate demanded
by investor to compensate for the risk
exposure
The risk that the securities will be easily sold
at the expected price (without reduction in
value)
Highly liquid assets carries lowest interest
rates
For Illiquid assets, investors will add a
liquidity risk premium
Special provisions or covenants in the contract
of an issuance of a security will effect interest
rates; examples callability, convertibility,
taxability
Thus, if the bond is tax free, the interest rate of
that bond is lower compared to a taxable bond
Provisions such taxability and convertibility
leads to a lower rates; but if provisions is to the
benefit to the issuer such as callability the
interest rates will bi higher
Refers to the length of time the security will
mature and this affect interest rates the ‘term
structure of interest rates’ or ‘yield curve’
The change in required interest rates as maturity
changes is called ‘maturity premium’
The ‘maturity premium’ can be positive (an
upward sloping yield curve), negative
(downward sloping curve) or zero ( a flat yield
curve)
