Interest rates have two effects on corporate profits:
a) Because interest rate is a cost, the higher the rate of interest the lower the firm’s profit other things held constant.
b) Interest rates affect the level of economic activities which affect the level of corporate profit.
Interest rates obviously affect stock prices because of the effect on profit but even more importantly they have an effect due to the competition in the market between shares and bonds.
If interest rates rise sharply, investors can get higher returns in the bond (money) market which induces them to sell shares (stocks) and transfer the funds from stock market to money market (Treasury bills).
Such transfers in response to increase in interest rates reduces demand for shares in the stock exchange and this obviously depresses the share prices e.g in mid and late 1993 the CBK intervened in the short term market where it floated Treasury Bills whose interest rate was as high as 88% well above the returns that can be expected from high yield stocks.
Accordingly, investors removed (misdirected) their money (funds) from the stock market into Treasury Bills.
The result was a stagnation of stock prices of quoted firms. Accordingly as CBK achieved its objective of reducing the money supply in the economy the interest rates declined well below 30% and the immediate effect was a rebuild in demand for shares and the share prices shot up instantaneously around February 1994.
Importance of Interest Rates
These are of a particular relevance to a finance manager because:
- They measure the cost of borrowing.
- Interest rates in a country influence the foreign exchange rate of the country’s currency.
- Interest rates act as a guide to the sort of return that firm’s shareholders might want hence changes in interest rates will affect rates for an approved creditworthy borrower.
Interest may be
- Base lending rates – Banks lend to individual and small firm’s at certain margins above the base lending rates. It is therefore the rates for an approved creditworthy borrower.
- Inter-Bank Lending rates
For large loans to big firms, banks will set interest rates at a margin below base rates rather than above base lending rates.
The Treasury Bills Rates – Risk Free
- The rates at much central bank sells treasury bills to the market.
- Treasury bills are used to raise, short-term funds for the government. Securities issued the government to raise long term funds are called gilt-edged securities.
- Why interest rates differ in different markets segments
Interest rates may differ in different market and market segment because of:
- Size of the loan: Deposits above certain amounts into the bank might attract higher interest rates than smaller deposits. Consequently, large borrowers would be charged higher interest rates than small borrowers.
- Risks: Higher risk borrowers must pay higher rates on their borrowing to compensate lenders for greater risks involved.
- The need to make a profit in re-lending: e.g banks borrow for depositors and charge higher interest (profit margin) when they lend to borrowers.
- Duration of the lending: The L.T. loans will earn a higher rate of interest than shorter term loans due to the maturity risk premium.
- International interest rates: This vary from one country to another due to differing rates of inflation and government policies on interest rates and foreign currency exchange rates.
- Different types of financial assets: Building societies must offer higher yields to depositors to attract them using bonds which have high rate of return.