Discuss about the Investment Risk Management And Economics.
For every industry in any given economy, it reaches a time when a need to source funding arises. External sourcing of funds other than from the company’s’ shareholders affect the revenue for the company since the borrowed loan has to be serviced. The cost of servicing loans is of utmost importance as it eats part of the revenue that the company generates. Thus, it is essential to ensure that loans are only obtained at a lower cost possible. The interest rate has been globally agreed to be the primary determiner of the loan servicing costs. Thus, interest rate has to be analyzed before taking any loans. This paper will tell us that even if the current interest rate is important, the future interest rate is also very important. What is mostly available is the current interest rate, the future interest rate can only be forecasted given certain macroeconomic conditions. The forecasting of future interest rate ensures that a company does not seek a loan whose interest rate is probably going to rise in the future. A rise in the future rate means that the firm’s profitability will be undermined during the future period. Given the corporate goal of maximizing profits, the firm needs to ensure a good flow of profits.
Since the interest rate can never be assumed to be constant for all periods, this paper will establish the different types of interest rate that one can choose from given the uncertainty in future. The two types of interest rates which are fixed and floating interest rates will be discussed and their effectiveness will be established. The paper will also determine how the supply of loanable funds will be affected by variations in the rates of interest. Given the discussion on the fixed and floating interest rate, the paper will enable one to make different choice of interest options presented. The paper will conclude on the most effective type of interest rate giving an explanation for the same. Lastly, this paper will cover the impacts of interest rate differentials among different economies. In this case, the interest rate of the US will be compared to that of the UK. It will be determined whether a change in the UK interest rate will positively or negatively impact the US interest rate. Given the result from the interest rate differentials, this paper will establish whether it’s also essential to consider the interest rate of other economies when making a decision to source funds.
The US economic growth has been noted to be very high over the past two years. A higher economic growth is desirable for an economy and thus it’s easier to forecast whether there would be a need in the future to vary the interest rate. If the growth continues to be stronger, it’s expected that there would be no need for expansionary policies of lowering interest rate. However, if there is an expectation that the economic growth is going to become stagnant, there might arise a need for expansionary policies of cutting interest rate. Thus, an expectation of economic growth stagnation may be good for obtaining loans since the servicing costs may fall in the future owing to a reduced interest rate. Fleming (2018) argued that there is a need for the US government to review its monetary policies in order to deal with the upcoming economic downturn. Based on this argument on the US economic growth changes, the interest rate in the future might be lower.
Over the last few years, the US inflation rate has stagnated at 3%. The inflation rate is a major determiner of the interest rate level in an economy. Inflation forces the government and the Central Bank to implement contractionary policies as it hurts the economy. The citizens’ standard of living is lowered by higher inflation rate as it lowers the purchasing power of the currency held. Higher inflation rate is believed to be cooled down mainly by raising the interest rate, on the contrary, an economy is stimulated by lowering the interest rate. The decision to vary the interest rate is driven by the level of the inflation rate given the inflation rate targeting. If the inflation rate is above the inflation rate targeting, there is a possibility that the Central Bank may raise the interest rate. However if the rate is below, the Central Bank may lower the interest rate.
Schneider (2017) pointed out that the US has an inflation rate targeting of 2%. Thus, the said level of 3% of which is expected to remain unchanged is higher than the target rate. Thus, future expectations may be compromised. The government may decide that its time it controlled the high inflation rate by employing a contractionary monetary policy where it will raise the rate of interest. Given the argument on the current high inflation rate above the target inflation rate, the interest rate can be forecasted to rise in the future. This will be bad for the investors who already obtain today at the existing low rates of interest. On the contrary economists like Fleming (2018) are arguing for a review on the US inflation rate targeting which might see the inflation rate target being revised to 3% in the future. The 2% inflation rate targeting for the US was introduced in 2012 and is accused of limiting the policies implementation by the government. For this reason, the expected stagnation of this economy will greatly hurt the economy as it will be having little expansionary options.
If a step was taken to raise the targeting in the coming years, there would be no further need to raise the rate of interest in order to control the said high inflation rate as it would be no more a threat. By raising the inflation rate to 3%, the US will be in a better position to deal with the upcoming recession as it will have a room for implementing expansionary policies; it will be able to lower the interest rate without risks of accelerating the inflation rate (Miller, 2018). If the target is revised, future interest rate will be lower. However, the current inflation rate is most likely to induce an interest rate cut as it is already below the current targeting of 2%. Lee and Hungerford (2018) pointed out that the close of 2018 interest rate will be 1.7% which will be a threat to the US economy. Given this condition and the future expectations of revising the inflation rate targeting, the interest rate is bound to be revised downwards.
The short term government securities yield curve have flattened on a range from 6-month treasury bills to notes of three-year. Kruger (2017) noted that the US has been faced with lower inflation rate and has continued raising the interest rate despite this condition. However, according to Kruger, its ammunition to raise the interest rate as the bond market is laying a bet is that there are only one or two more chances for this interest rate raise. The interest rate may therefore fall in the future. Since July 2009, the US economy has been undergoing an expansion which has been considered it’s third-longest. Its stock prices are currently at record high. This is the reason for the warmish growth in the price level as measured by personal consumption expenditure.
Government spending determines the level of income for the citizens. A higher government spending raises the income for households. However, a lower spending causes a decline in the households’ income. The following illustration shows how the cut in government spending directly impacts the households’ income and the interest rate through the multiplier.
Decreasing the government spending from g0 to g1 reduces y directly through the multiplier such that the initial y0 now falls to y1. The decrease in y reduces demand in the money market ensuing r to fall to r2. The lower r cause investment to rise and the multiplier causes the economy to settle at r2y2. From the above analysis, the decrease in the spending by the government is expected to lower the interest rate. Thus, in future the interest rate may be supportive for the sourcing of loans.
The market interest rate and the price for bonds have been observed to have an inverse relationship. Given the bond’s par value and coupon, an increase in the interest rate have been observed to lower its selling price. Similarly, a cut in the rate of interest in the market has been observed to raise the bond prices. The initial price of the bond will remain fixed only if the bond at issue is selling at a discount and fails to have a coupon; the market changes in interest rate is covered by adjustment in the market price. Since the yield rate to newly issued bonds have to be equal, the market interest rate variations results in price adjustment for the outstanding bonds. Based on this argument, with an expectation of a future cut in interest rate, it’s worthwhile to issue bonds to raise capital as the future prices will be higher.
The equilibrium in the demand and supply of loanable funds assumes that the government is in a balanced budget state (Mankiw, 2012). The supply for loanable funds is determined by the level of savings by the private sector, public sector and foreign savings (Spaulding, 2018). Public savings is the disposable income that is left unspent; public saving is the difference between government’s revenue and expenditure; and foreign saving is exports minus imports (Mceachern, 2009). The public savings for the US is negative as it is on budget deficits.
There is a positive relationship between the market interest rate and the supply for loanable funds. The opportunity cost for consumers is raised by high interest rate; thus, they forego consumption to raise savings (Gallego, 2017). The change in the supply of loanable funds shifts the supply curve either inwards of outwards. Since the government is expected to hold constant the supply for loanable funds, there will be no shift in the supply curve, meaning that, supply will remain to be at level LF* and interest rate at i*. The household’s saving is also expected to remain constant and this also will not influence the interest rate.
The US interest rate is forecasted to fall in the future. This is because, the economic growth for the US economy is project to be stagnant creating a need for interest rate cut. The US state inflation rate is below the target of 2% and thus interest rate cut may have positive impacts. The reduction in government spending will push down the interest rate. The supply of loanable funds is expected to be held constant.
London Interbank Offered Rate (LIBOR) is the rate for short-term loans charged by World’s leading banks on each other (Merced, 2012). It is the first step that helps in the calculation of interest rate. The maturities served by LIBOR are seven: overnight, 1 week, and 1, 2, 3, 6 and 12 months. Libor uses the creditworthiness of the bond issuing institution to set the spread for the bond’s payment (Bbc.com, 2015). The banks in the US estimates the interest they would pay to obtain short-term loan from other institutions and averages this to get a benchmark. Now the interest of loan is set by adding an interest of say 2% above the LIBOR benchmark to accommodate the riskiness of the borrower.
A fixed interest loan has a fixed interest rate till maturity while a floating interest loan has a varying interest rate. The advantages of fixed interest loan is that: one is able to estimate the costs of the loan; its predictable; when current interest is low, borrowers lock in low interest rate; the terms are more flexible; and tax benefits can be estimated easily (Fox, 2018). The disadvantages are: high monthly interest payment; lock in problem if unable to service the loan (Freeandclear.com, 2018). The advantages of floating interest loan is that one enjoys low rates and that one gains in market interest rate becomes favorable (Wilkinson, 2013). The disadvantage is that budget is difficult to make as the monthly payment are unequal; further, if the rate rises, the servicing cost goes up (Baker and Filbeck, 2015).
In this case, it is advisable for one to take the floating interest loan. This is because the rates of interest are forecasted to fall in the future and this will lower the future loan servicing costs. The future monthly payments will be smaller than the current payments; there will be much benefits.
High interest rate lowers the demand for money causing a rise in the value of the currency (Pettinger, 2016). Similarly, a lower rate increases demand and the value of currency falls. The high interest rate in UK will increase its flow of money even from outside savers; savers will find it more profitable to save in the UK. This will raise the supply of money in the UK. The interest rate parity will enable the US investors to shift their savings to the UK and this will lower the supply of loanable funds. All this will happen in the short-run. In the long-run, the higher interest rate arising in the short run will make it more attractive for savers, this will again restore the supply of loanable funds and the initial equilibrium level will be restored by a rightward shift from ‘Supply 2’ in the graph below.
Conclusion and Justification
I won’t change my decision for choosing a floating interest loan even after the interest rate in the UK goes up since in the long-run, the lower interest rate in the US will be restored. The high monthly payments will only be made in the short-run.
Bbc.com (2015). Libor: What is it and why does it matter? [Online] BBC News. Available at: https://www.bbc.com/news/business-19199683 [Accessed 22 May 2018].
Baker, K., and Filbeck, G. (2015). Investment risk management. New York, NY: Oxford University Press.
Fleming, S. (2018). Fed’s Dudley backs review of 2% inflation target. [Online] Ft.com. Available at: https://www.ft.com/content/aedc9d50-fc69-11e7-a492-2c9be7f3120a [Accessed 22 May 2018].
Fox, E. (2018). Fixed-Rate Mortgage Loans: Pros And Cons Revealed. [Online] Get.com. Available at: https://www.get.com/mortgages/fixed-rate-mortgage-loans/ [Accessed 22 May 2018].
Freeandclear.com. (2018). Fixed Rate Mortgage Pros and Cons. [online] Available at: https://www.freeandclear.com/resources/mortgage-insights/fixed-rate-mortgage-pros-cons [Accessed 21 May 2018].
Gallego, L. (2017). Loanable funds. [Online] Policonomics.com. Available at: https://policonomics.com/loanable-funds/ [Accessed 22 May 2018].
Kruger, D. (2017). Here’s Why The Fed’s 2% Inflation Target Isn’t, And Is, A Big Deal. [Online] Forbes.com. Available at: https://www.forbes.com/sites/danielkruger/2017/08/23/heres-why-the-feds-2-inflation-target-isnt-and-is-a-big-deal/#d0743d27be28 [Accessed 21 May 2018].
Lee, Y. and Hungerford, N. (2018). Fed likely to be disappointed with inflation again this year, UBS says. [Online] CNBC. Available at: https://www.cnbc.com/2018/01/09/ubs-us-chief-economist-inflation-to-end-2018-below-federal-reserve-target.html [Accessed 21 May 2018].
Mankiw, N. (2012). Principles of macroeconomics. 6th ed. Mason, Ohio: Cengage Learning.
Mceachern, A. (2009). Economics: a contemporary introduction. Mason, OH, South-Western Cengage Learning.
Merced, M. (2012). Q. and A.: Understanding Libor. [Online] DealBook. Available at: https://dealbook.nytimes.com/2012/07/10/q-and-a-understanding-libor/ [Accessed 22 May 2018].
Miller, M. (2018). Is the Fed’s Inflation Target Kaput? [Online] Bloomberg.com. Available at: https://www.bloomberg.com/news/articles/2018-02-02/is-the-fed-s-inflation-target-kaput [Accessed 22 May 2018].
Pettinger, T. (2016). Interest Rates and Exchange Rate. [Online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/5394/interest-rates/interest-rates-and-exchange-rate/ [Accessed 23 May 2018].
Schneider, H. (2017). Is the Fed ready to consider lifting its inflation target? [Online] U.S. Available at: https://www.reuters.com/article/us-usa-fed-inflation-analysis-idUSKBN19630N [Accessed 20 May 2018].
Spaulding, W. (2018). Interest Rates and Loanable Funds. [Online] Thismatter.com. Available at: https://thismatter.com/economics/interest-rates-loanable-funds.htm [Accessed 22 May 2018].
Wilkinson, J. (2013). Fixed Interest Rate vs Floating Interest Rate. [Online] The Strategic CFO. Available at: https://strategiccfo.com/fixed-interest-rate-vs-floating-interest-rate/ [Accessed 22 May 2018].
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