Interest rate: The price of money

January 25, 2013
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In my last post ‘Debt – A powerful tool’ we spoke about debt. Some readers had some confusion and hence, I want to take a simple example to help realize the power of debt. Let’s say you want to buy a piece of land which is worth Rs. 200 and you have Rs. 20. You go to your very reliable friend and ask for Rs. 180. He pays you instantly and things become easy. You buy the piece of land. Suddenly the price of that piece of land went up to Rs. 300. You sell the land and pay back your friend the Rs 180 you owed him and pocket Rs. 120. On your initial investment of Rs 20, you end up making a profit of Rs 100! This is the power of debt. But, did we pay our dear friend for lending the money to us? No. But we should have. In other words, we should have paid him interest.

Before we dive in and learn interest, we should understand why we should pay a price for our friend’s help. Let’s say he asks for 10% as interest. Your friend lends money to you because he wanted something more in future. He thought that money received in future will be worth more. Let’s say there is one more friend of yours who is ready to lend you money for less price i.e. interest. He asks for 8%. What is the difference? The difference mathematically is 2%. In other words, for your new friend, the value of money today is slightly less than your old friend. This brings us to the value of money for two of your friends.

Why the same amount of money is valued differently by two of your friends? To solve this puzzle, we ask a simple question. The question is what is the price of money? To explain it lets think that there are large number of people who want money and there are other set of people who want to lend money. To arrive at a price, they just went about trading till they reach a point where any more lending or borrowing does not change the price. Wow! so much amount of work to arrive at a price. Let’s remember this when we think about price.

The price or interest is determined in a similar way in an economy. Everything that we think of in an economy including stocks, bonds, commodities etc. depends on this price of money. To solve this complexity, a regulatory body is assigned which is RBI that monitors this movement of price. And banks are there to facilitate the flow of money. They lend money when money is not available and borrow money when money is more in an economy.  RBI then figures out the price of money which is paid by banks when they borrow from RBI. This is the base price or base interest rate which is 8%.          

You can refer following link for base rate -

http://www.allbankingsolutions.com/Banking-Tutor/Chronology-Repo-Rate-India.shtml  

Now your friend who lends you money thinks about this base rate. He can lend you money but he thinks that there is a risk. He adds some premium to this base price which is 10% – 8% = 2%. The extra money that he charges is the premium you pay depending on your credit worthiness. The other friend believes that you are more likely to return the money and hence he charges no premium.

This risk premium is no different than what is paid by corporations. Corporations are much more complex than you and me. They do lots of stuff such as production, marketing etc. and produce merchandise which is sold in the market. Let’s say we are a bank. We can forecast how much they will sell in future. Depending on the nature of their business and our ability to forecast, we will lend money to them. In today’s market we also check whether they paid back the money borrowed in past. Now we are confident about our research and decide to lend them money albeit with some premium.

Let’s consider a company like Reliance Industries which pays 4% as interest. Why interest is low for Reliance? The size of the corporation is also important. A large corporate like Reliance is more stable and likely to sell its produce in the market. This is called the competitive edge. When we go to a local market, we know that the biggest shop is more likely to sell than a smaller one. This is true for any market. We can reduce the risk premium in such a case and charge possibly somewhat around base rate. This is the reason why companies like Reliance pay a much lower price of money they borrow. They even reduce the risk for a bank. Bank is lending to so many corporate entities. They are continuously building upon their risk to lose money. To manage risk, banks identify market players such as Reliance who are reliable enough to pay back a large amount of their money. Hence Reliance pays less price i.e. interest.

You can understand now interest is the price and this price can change the way every financial instrument performs. I forgot to mention one thing while writing this article. The price keeps on changing so price of money today is different than price tomorrow. This means that what you will get by borrowing today is different than what you borrow tomorrow. In the next article, I will discuss how value of money changes over time and effect of interest rates.       

   

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Devendra Mangani

Devendra Mangani

Devendra is working in curriculum development and assisting finance faculty at Sunstone. He has worked with RBC capital markets, an investment bank in Canada and global manufacturing organization in various roles.
He is a graduate from IIT Bombay and holds an MBA from Queen’s School of Business, Canada.

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