Distinction Between Rate of Interest and Interest Yield

Every loan arrangement has following clearly specified:

1. The loan amount or principal or face value;
2. The rate of interest or coupon rate;
3. Frequency of payment of interest – quarterly or half yearly or annually;
4. Repayment terms, including:

• The date of repayment or redemption or maturity;
• Weather repayable in one shot (bullet repayment) or installments;
•  If repayable in installments:

• Frequency;

• The quantum or amount payable;

‘Rate of Interest’ is the rate at which the borrower agrees to pay interest on the loan amount or principal outstanding or the face value of the instrument.

Where the loan or loan instrument, namely bond is not tradable then the investor has no option but to hold the instrument till maturity. The borrower will repay the face value in full. During the loan period the investor will receive the interest at the specified rate of interest. In this case there is question of yield or we can express the same thing in another way that the rate of interest and yield are one and the same.

Bond Example

When a company borrows through marketable securities like bonds, interest yield comes into play, because the bond can be purchased at a price more or less than the face value. Interest yield, therefore is the rate of interest actually earned by the investor on the amount invested. Following example makes the aforesaid amply clear:

Example Showing Interest Yield

In conclusion, ‘Rate of Interest’ is the specified rate of interest on the face value of the loan or bond, whereas ‘Interest Yield’ is the rate of interest actually realized on the amount really paid for purchasing the bond in the open market.

What is US Federal Reserve and How will a Fed Rate Hike Affect the Indian Stock Market?

Every country has a central bank akin to our own the ‘Reserve Bank of India (RBI)’ to regulate the commercial banks and craft and implement the the country’s monetary policy. The ‘US Federal Reserve’ is the central bank of the US.

Central banks world over usually discharge following functions:

1. Regulate functioning of commercial banks in various ways.
2. Monitor and control liquidity in the economy by mopping of excess liquidity in the system (by borrowing, raising limits of compulsory reserves like CRR and SLR) and creating liquidity where there is a shortage (recent Quantitative Easing measures of the US is an example).
3. Determining the Interest Rates through the ‘Repo and Reverse Repo Rates’.
4. Monitoring and controlling ‘Inflation’ or ‘Price Rise’ through the different monetary measures discussed above.

Although stagnant or on a slight decline for a decade perhaps, the US still is a great nation. Even though her economy is not in great shape (the US today carries the highest external debt in the world), in the absence of a credible alternative, its currency remains the last resort in an increasingly turbulent global economy.

In an effort to revive her sagging economy, the successive US governments, aided by the Federal Reserve, have been implementing following stimulus measures:

1. Enhancing liquidity in the system through the most controversial and undesirable ‘Quantitative Easing’ or in plain words ‘Printing of Money’.
2. In order to boost investment, maintaining negative or ridiculously low interest rates.

Since fortunately or unfortunately the US continues to be the dominant global power, her actions, including those of the Federal Reserve impact the world economies and financial markets, including the Indian stock market as follows:

1. Excess Liquidity: Though meant for boosting domestic investment, cash invariably flows out and floods world markets. This results in a lot of money chasing a small number of stocks and other financial instruments. As per the latest study published by ‘Value Research’ an incredible 40% of the free floating shares of the Indian stock market is held by Foreign Institutional Investors or FIIs. This in-turn drives up valuations to absurdly high levels, making many goos stocks unaffordable to value investors.
2. Maintaining low interest rates for long periods of time adversely impact the interest incomes of majority of common population - ultimately affecting internal savings and investments, which was the goal of the measure in the first place! Additionally it aids the flow of money from the US to global markets, especially emerging economies like India, in search of better interest rates and other investment returns.

In this overall scenario, in the light of signals emerging from the the US economy that it is strengthening and realising in hind sight that the stimulus measures are hurting the economy the Federal Reserve is attempting a course correction by restoring healthy interest rates gradually.

Having covered the basics and understanding the background let us now address your question in the following paragraphs.

1. An increase in interest rates by the US Federal Reserve will have the impact of reversing the outward flow of liquidity. The FIIs will find it little more attractive to invest in their own home country. As a result they start selling their holdings in the world markets, causing a fall in stock prices globally.
2. In addition, an increase in interest rates at home will make the Dollar stronger and conversely the other countries currencies, including the Indian Rupee, weaker. This will force the hands of FIIs to sell immediately, as otherwise they will face a double loss:

• A loss on sale that is certain to arise by selling latter in a falling market.
• The currency exchange loss; when the Indian rupee depreciates, rupees 68 will fetch one dollar today will fetch less than a dollar after a week.

In the end, when the Fed increases rates, global markets will fall and liquidity in the global markets will reduce drastically. There is no doubt abiout this.

Real impact of market correction 

Is such a steep fall or deep correction of the Indian Stock Market good? Yes, it is really very good for the investors. Please note that excess liquidity chasing the small available floating stock has driven-up the valuations to unreasonable levels. While prudent investment guidelines prescribe a PE Ratio of 10 based on past five years earnings, the market today is trading at over 15 of expected, future earnings of the financial year 2016–17. As a result, real investors like you and I are unable to afford to buy shares at these levels.

In conclusion, the Indian stock market will correct on the back of the US Fed increasing interest rates, as and when it happens, and I as a value investor is eagerly looking forward to that day when I will be able to afford to buy many great Indian companies’ stocks like 'Infosys Ltd.', which I cannot afford presently.

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.

What are Repo and Reverse Repo Rates?

Dear Mr.Satinderpal Singh

Sorry for the delay in answering, a good question.

First address the meaning of these two terms and then their significance.

The ‘Repo Rate’ is the rate at which the Reserve Bank of India (RBI) is willing to lend money to commercial banks. The ‘Reverse Repo Rate’ is the rate at which the RBI is willing to pay to accept surplus money lying with commercial banks.

Now let us address the significance of these rates. These rates have the significance of influencing the market interest rates for the whole economy. There is no direct and binding linkage between the RBI denominated rates and banks’ rates but it only has indirect, persuasive influence. When RBI lowers the two rates, it is sending a strong and clear signal that RBI believes the lending and deposit rates need to go down. The actual reduction achieved out of competition. One bank takes the cue and reduces its rates and others will follow. This is called the transmission of interest rate changes.

However, it has happened in the recent past that the commercial banks refused to transmit the rate cuts, forcing the RBI to intervene (again only persuasive) and speak out that there was a clear need for transmission of the rate cut.

Converse persuasion attempts were also made in the recent past where the central government and commercial banks desired a rate cut but the RBI did not oblige and the commercial banks went ahead on their own and cut rates thus putting pressure on the RBI to cut Repo and Reverse Repo rates.

In conclusion Repo and Reverse Repo rates are RBI’s interest rate policy tools that strongly influence the general lending and deposit interest rates by commercial banks and other financial institutions.

Thank you,

With Best Regards,

Anand

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.