Interest rates are determined by the interaction of supply and demand in the market for loanable funds. The supply comes from domestic savings, foreign lending, and money creation by banks. The demand comes from consumers, businesses, and governments seeking credit, as well as foreign borrowers. Equilibrium is reached where the supply and demand for loanable funds are equal. Factors such as expected inflation, default risk, liquidity risk, and monetary policy influence the supply and demand curves and thus impact interest rate levels.

1. DETERMINATION OF INTEREST RATE IN
NEPALESE FINANCIAL MARKET

2. Interest Rates – Role and its
Importance

3. Interest Rate
• The acts of saving and lending, and borrowing
and investing, are significantly influenced by and
tied together by the interest rate.
• The interest rate is the price a borrower must pay
to secure scarce loanable funds from a lender for
an agreed-upon time period.
• Interest rates, in general, reflect the cost of funds-
the interest rate can be viewed as the rental price
for money (opportunity cost for money).

4. • effect of policy rate to the market interest
rates depends on the structure of interest
rates and the level of financial development
• All business organizations or individuals are
responsive to interest rate of banks and
financial institutions in one-way or another.
Interest rate structure is the relationship
between maturity and yield in order to
determine bow the bond portfolio behaves in
matching the maturity structure

5. Interest rate structure depends upon
a) the behavior of the yield curve
b) composition of the maturity structure
c) sensitivity of the change in the interest rate
and
d) default risk included in matching the level of
interest rate and its relationship with the
yield curve.

6. Phases of Interest Rates

7. Pre Interest Rate Phase (pre-1955):
Prior to 1955, the domestic financial system was
underdeveloped - it was dominated by
unorganized/informal financial system generally
driven by private individuals, merchants and
landlords
• To provide financial services, Nepal Bank Limited was
established in 1937, and reflects the start of the
formal financial system.
• Therefore, in the initial period, the primary
responsibility for Nepal Rastra Bank was to bring the
monetary system under its control - this was reflected
in the preamble of the Nepal Rastra Bank Act of
1955.

8. Controlled Interest Rate Phase (1956 - 1983)
• The establishment of Nepal Rastra Bank
(NRB) in 1956 coincided with the period of
planning
• In this year, NRB also adopted a controlled
interest rate determination regime, where the
Bank used to fix deposit and lending rates of
the commercial banks.

9. Transitional Interest Rate Phase (1984 - 1989):
• In early 1980s, Nepal experienced a series of
BOP problem. To control the depletion of
international reserve Nepal adopted the
International Monetary Fund's (IMF)
• In this regard, on November 16, 1984 NRB
initiated a limited flexibility to commercial
banks to fix the interest rates.
• Commercial banks were then allowed to offer
interest rate on savings and time deposits to the
extent of 1.5 and 1.0 percentage point above
the minimum level.

10. Liberalized Interest Rate Phase (1990 -
present): Controlled interest rate
• Regime was completely abolished on August
31, 1989.
• Banks and financial institutions were now
given full autonomy to determine their interest
rates on deposits and lending.

11. Theories of Interest Rates

12. The Classical Theory of Interest Rates
• The classical theory argues that the rate of
interest is determined by two forces:
 the supply of savings, derived mainly from
households, and
 the demand for investment capital, coming mainly
from the business sector.

13. Household Savings
• Current household savings equal the
difference between current income and
current consumption expenditures.
• Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
• Higher interest rates encourage the
substitution of current saving for current
consumption.

14. Business and Government Savings
• Most businesses hold savings balances in the
form of retained earnings, the amount of
which is determined principally by business
profits, and to a lesser extent, by interest
rates.
• Income flows in the economy and the pacing
of government spending programs are the
dominant factors affecting government
savings (budget surplus).

15. The Classical Theory of Interest Rates
The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate
Savings &
Investment
rE
QE

Investment Savings

16. The Loanable Funds Theory of Interest

17. The Loanable Funds Theory of Interest
• The popular loanable funds theory argues that
the risk-free interest rate is determined by the
interplay of two forces:
 the demand for credit (loanable funds) by
domestic businesses, consumers, and
governments, as well as foreign borrowers
 the supply of loanable funds from domestic
savings, dishoarding of money balances, money
creation by the banking system, as well as foreign
lending.

18. The Loanable Funds Theory of Interest
The Demand for Loanable Funds
• Consumer (household) demand is relatively
inelastic with respect to the rate of interest.
• Domestic business demand increases as the rate
of interest falls.
• Government demand does not depend
significantly upon the level of interest rates.
• Foreign demand is sensitive to the spread
between domestic and foreign interest rates.

19. The Loanable Funds Theory of Interest
Total Demand for Loanable Funds (Credit)
Interest
Rate
Amount of
Loanable Funds
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign

20. The Loanable Funds Theory of Interest
The Supply of Loanable Funds
• Domestic Savings. The net effect of income,
substitution, and wealth effects is a relatively
interest-inelastic supply of savings curve.
• Dishoarding of Money Balances. When
individuals and businesses dispose of their
excess cash holdings, the supply of loanable
funds available to others is increased.

21. The Loanable Funds Theory of Interest
• Creation of Credit by the Domestic Banking
System. Commercial banks and nonbank thrift
institutions offering payments accounts can
create credit by lending and investing their
excess reserves.
• Foreign lending is sensitive to the spread
between domestic and foreign interest rates.

22. The Loanable Funds Theory of Interest
Total Supply of Loanable Funds (Credit)
Interest
Rate
Amount of
Loanable Funds
Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand

23. The Loanable Funds Theory of Interest
The Equilibrium Interest Rate
Interest
Rate
Amount of
Loanable Funds
rE
QE

Demand
Supply

24. The Loanable Funds Theory of Interest
• At equilibrium:
 Planned savings = planned investment across the
whole economic system
 Money supply = money demand
 Supply of loanable funds = demand for loanable
funds
 Net foreign demand for loanable funds = net
exports

25. The Loanable Funds Theory of Interest
• Interest rates will be stable only when the
economy, money market, loanable funds
market, and foreign currency markets are
simultaneously in equilibrium.

26. Term Structure Theory of Interest Rates

27. Term Structure of Interest Rates
• The term structure of interest rates is the
relationship between the yield to maturity and
the time to maturity for pure discount bonds.
• The term structure of interest rates is of
fundamental importance in macroeconomics
because monetary policy affects short-term
interest rates, but investment depends on
long-term interest rates.

28. • The term structure of interest rates, also called
the yield curve, is a graph that plots the yields of
similar-quality bonds against their maturities,
from shortest to longest.
• The term structure of interest rates shows the
various yields that are currently being offered on
bonds of different maturities. It enables investors
to quickly compare the yields offered on short-
term, medium-term and long-term bonds.

29. Term Structure Facts
to Be Explained
Besides explaining the shape of the yield curve, a
good theory must explain why:
1. Interest rates for different maturities
move together.
2. Yield curves tend to have steep upward slope
when short rates are low and downward
slope when short rates are high.
3. Yield curve is typically upward sloping.

30. Yield Curves

31. TERM STRUCTURE THEORIES
Pure Expectations Theory
• Key Assumption: Bonds of different maturities are
perfect substitutes
• Implication: Bonds of different maturities
are equal
• Investment strategies for two-period horizon
1. Buy $1 of one-year bond and when matures buy another
one-year bond
2. Buy $1 of two-year bond and hold it

32. • Explains why yield curve has different slopes
1. When short rates are expected to rise in future, average
of future short rates = int is above today's short rate;
therefore yield curve is upward sloping.
2. When short rates expected to stay same in future,
average of future short rates same as today’s, and yield
curve is flat.
3. Only when short rates expected to fall will yield curve be
downward sloping.

33. Liquidity Preference Theory
• Key Assumption: Bonds of different maturities
are substitutes, but are not perfect substitutes
• Implication: Modifies Pure Expectations
Theory with features of Market Segmentation
Theory
• Investors prefer short-term rather than long-
term bonds. This implies that investors must
be paid positive liquidity premium, lnt, to hold
long term bonds.

34. IF LT bond yields have a liquidity premium,
then usually LT yields > ST yields
or yield curve slopes up.

35. The Liquidity Preference (Cash Balances) Theory
of Interest Rates
The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate
Quantity of
Money / Cash
Balances
rE  Total
Demand
QE
Money
Supply

36. Limitations
• The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
• Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.

37. Market Segmentation Theory
• Key Assumption: Bonds of different maturities
are not substitutes at all
• Implication: Markets are completely
segmented; interest rate at each maturity are
determined separately
• if assumption is true,
– separate markets for ST and LT bonds
– slope of yield curves tells us nothing about future ST
rates
• unrealistic to assume NO substitution bet. ST and
LT bonds

38. Interest Rate Risk- Types and
Techniques

39. Interest rate risk
• Interest rate risk is that which exists in an
interest-bearing asset, such as a loan or a bond,
due to the possibility of a change in the asset's
value resulting from the variability of interest
rates.
• Interest rate risk is the effect on prices and
interim cash flows caused by changes in the level
of interest rates during the life of the financial
asset.

40. Continue….
• The movement of interest rates affects a financial
institutions reported earnings by changing:
Net interest income
The market value of trading accounts
Other interest sensitive income and expenses,
such as mortgage servicing fees.
• It is risk that an investment's value will change
due to a change in the absolute level of interest
rates.

41. Type of Interest Rate Risk
Re pricing Risk
• It is maturity mismatch risk because the
greater the maturity of any investment,
greater the change in price for a given change
in the interest rates.
• The re pricing risk is analyzed by the gap,
duration & scenario techniques.

42. Continue…
Yield curve risk
• Yield curve risk is the result of price changes
induced by the changing slope of the yield
curve.
• Such risk usually arises when a liability is
matched with a combination of assets that
has the same duration but different in cash
flows.

43. Continue….
Basis risk
• It arises from imperfect correlation in the
adjustment of the rates earned and paid on
different instruments with otherwise similar re-
pricing characteristics.
• When interest rates change, these differences can
give rise to unexpected changes in the cash flows
and earnings spread between assets and
liabilities of similar maturities.

44. Continue…
Option Risk
• Option risk arises due to the change in assets
and liabilities durations when change occurs in
interest rates.
• It also arise from the prepayment, cap, floor
and other options embedded in underlying
mortgages, term deposits & other products.

45. Continue….
Prepayment/Extension Risks:
• The risk that asset repayments accelerate at a
time when interest rates are low, resulting in
diminished interest income and the need to
reinvest repaid funds in lower-yielding assets.
• This risk intensifies when loan customers or
bond issuers exercise their explicit call options
to pay off the bank’s asset prior to maturity
and interest rates decline.

46. Tools and Techniques for Minimizing
Interest Rate Risk
Interest Rate Swaps
• is a contractual agreement between two
parties to exchange interest payments on set
dates in the future.
• A company will typically use interest rate
swaps to limit or manage exposure to
fluctuations in interest rates.

47. Continue….
Interest Rate Caps
• An interest rate cap is a derivative in which the
buyer receives payments at the end of each
period in which the interest rate exceeds the
agreed strike price.
• There are several different types of interest rate
cap structures including an initial, periodic and
lifetime interest rate cap structure.

48. Continue…
 Forward Rate Agreement
• FRA is a forward contract between parties that
determines the rate of interest to be paid or
received on an obligation beginning at a
future start date.
• The contract will determine the rates to be
used along with the termination date and
notional value.

49.  Financial Future Contract
• It is a futures contract on a short term interest
rate.
• A contractual agreement, generally made on
the trading floor to buy or sell a particular
commodity or financial instrument at a pre-
determined price in the future.
Continue…

50.  Interest Rate Collar
• It is an investment strategy that uses
derivatives to hedge an investor's exposure to
interest rate fluctuations.
• This strategy protects the investor by capping
the maximum interest rate paid at the collar's
ceiling, but sacrifices the profitability of
interest rate drops.
Continue…

51. Factors Affecting Interest Rates

52. Factors Affecting Interest Rates
1. Expected inflation
2. Default Risk
3. Liquidity Risk
4. Demand and supply of money
5. Income Taxes Factor
6. Production opportunities
7. Time preferences for consumption

53. Expected Inflation
• Continual increase in price of goods/services
• Over time, as the cost of products and services increase,
the value of money decreases.
• As for finance lending sector, borrowers may find it is
attractive to borrow now but less attractive for lender.
The value of money now has fallen as compared to the
time when they lent their money. In order to compensate
this loss, lenders have to increase the interest rate.
• Higher expected inflation, higher interest rates

54. Default Risk
• Default Risk occurs when the issuer of the bond is
unable or unwilling to make interest payments when
promised.
 The spread between the interest rates on bonds with
default risk and default-free bonds, called the risk
premium, indicates how much additional interest
people must earn in order to be willing to hold that
risky bond.
 A bond with default risk will always have a positive
risk premium, and an increase in its default risk will
raise the risk premium.
 Higher (lower) risk, higher (lower) interest rate.

55. Increase in Default Risk
on Corporate Bonds
1. Risk of corp. bonds , Dc ,
Dc shifts
2. Excess Supply  Pc , ic 
1. Relative risk of T bonds , DT
, DT shifts right
2. Excess Demand  PT , iT 

56. Liquidity Risk
 A liquid asset is one that can be quickly and cheaply
converted into cash. The more liquid an asset is, the
more desirable it is (higher demand), holding
everything else constant.
 For e.g. Treasury Bonds are the most liquid of all
long-term bonds.

57. Demand and Supply of money
• Supply and demand is a fundamental concept in market
economy.
• Supply refers to the level of quantity of services or
products can be offered, while demand refers to the
quantity required for the services and products. Demand
and supply of money can affect interest rates.
• For e.g. In US, The Federal Reserve Bank has taken a
step to manipulate money supply through an open market
operation, by purchasing large volumes of government
security to increase money supply, thus reduce the
interest rates or vice versa.

58. Income Taxes Factor
• Interest payments on municipal bonds are exempt
from federal income taxes.
• For the same before tax yield, their expected after
tax returns are higher.
• Treasury bonds are exempt from state and local
income taxes, while interest payments from
corporate bonds are fully taxable.

59. Production Opportunities
• Production opportunities are the investment
opportunities in productive (cash-generating) assets
Time Preferences for Consumption
• Time preferences for consumption are the preferences
of consumers for current consumption as opposed to
saving for future consumption.
• The higher value on current (future) consumption, the
higher (lower) the interest rate

60. Monetary Policy
• Monetary policy is the process by which the monetary
authority of a country controls the supply of money, often
targeting a rate of interest for the purpose of
promoting economic growth and stability.
• Monetary policy decisions involve setting the interest rate on
loans in the money market.
• The official goals of monetary policy usually include relatively
stable rates and low unemployment.

61. Economic Growth
• Rate of interest that is determined in the
market is also affected by economic growth.
• If there is positive economic growth then this
leads to increase in interest rate in the market
and vice versa.

62. Determinants of interest rates
Nominal interest rate in the absence of inflation
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium (Пe)
DRP = default risk premium (see p. 183)
LP = liquidity premium (illiquidity)
MRP= maturity risk premium (time)

63. Determinants of interest rates
r = Represents any nominal rate
r* = Represents the “real” risk-free rate of
interest. Like a T-bill rate, if there was no
inflation. Typically ranges from 1% to 4%
per year.
rRF = Represents the rate of interest on default
risk-free Treasury securities.

64. DETERMINANTS OF INTEREST RATE IN
NEPALESE FINANCIAL MARKET

65. MONEY DEMAND

66. MONEY SUPPLY

67. Determination of interest rate
Supply of
Loanable funds
Demand of
loanable funds
0 Quantity of loanable funds
Priceofcredit,investment
Rate of interest
Volumeofcredit

68. • Interest rate is regulated by the central bank during the early stage of
financial market development taking the period from 1955 to 1965.
• Country's central bank namely Nepal Rastra Bank gradually began to
liberalize the determination of interest rate on a phase-wise basis
according to compatibility, efficiency and maturity of the banks and the
financial institutions that have developed in the country.
• But for national interest from the monetary stability view point, Nepal
Rastra Bank can get in the way in guiding the banks and financial
institutions to relate interest rate to economic growth.
• Nepal Rastra Bank determines the interest rate on Government
Development Bond and National Saving Certificate
• At present, deregulation of the interest rate as result of economic and
financial liberalization has brought autonomy and determination of the
level of interest rate to the banks and financial institutions guided to
follow the directives of the unified Umbrella Act.

69. CURRENT SCENARIO O F INTEREST RATE IN
NEPALESE FINANCIAL MARKET

70. Interest rate structure in Nepal
• Interest rate charged differ in government securities, refinances of
loan, commercial bank deposit and loan floated by other financial
institutions in this five year period from 2002 to 2007.
• In T-bills, interest rates decreased from 4.94 percent in 2002 to
3.95 percent in 2004.
• In National savings bond, Interest rate recorded 7.13 percent in
2004 and legal of development bond recorded 3.8 percent in 2004.
• Refinancing rate of NRB varied from 2 percent to 5.5 percent in
2004.
• During same period refinance rate against foreign currency loan
is 2 percent during same period.

71. Cont...
• The deposit rate of these commercial banks varies from 2 periods
to 7.5 period taking savings deposit and various time deposits of
minimum 3 months to 2 years and above in 2004.
• Then lending rates vary from 4 percent to 16 percent for kinds of
loan offered such as industrial loan. agricultural loan, export bills,
commercial loans and overdrafts.
• The interest rates charged by other financial institutions are from
10 percent to 10 percent.
• But in 2005 the Treasury bill rate is 3.94 percent and it decreases to
3.13 percent in 2006.
• At the same time the development bank remains at the constant
rate of 6.5 percent to 13 percent.

72. Cont...
• But the development bond rate varies from 3 percent to 8 percent.
• The refinance rate of the Nepal Rastra Bank decreases to 1.5 percent
to 6 percent in 2006.
• The deposit rate of commercial bank for 3 months to 2 years is 2 to 5
percent in 2006.
• lending rate is 8.25 percent to 13.5 percent in case of industry,
agriculture, commercial loans and overdraft.
• But for other financial institutions the interest rate varies from 10.5
percent to 13.5 percent.
• The percent per annual interest rate has varied from 3.13 to 2.13
percent in T-bills during 2007 and national savings, it has decreased
to 8.15 percent and development bonds provide the maximum
interest rate 6.75 percent.

73. Cont...
• The refinancing rate of NRB has decreased to 3.5 percent
and in case of foreign loans it comes to 3.25 percent.
• In case of commercial banks, interest rate on deposits
increased slightly 5.5 percent although, the pressure of
liquidity has raised interest rate 6 percent and maximum to 7
percent.
• The lending rate of commercial banks has increased to 14.4
percent.
• For other financial institutions the interest rate in 14 percent.
• At present, NRB as well as the investors are finding the
interest rate provided by banks is not compatible to the
market interest rate.

74. FUNCTIONS OF INTEREST RATE IN AN
ECONOMY

75. • The interest rate influences inflation indirectly via domestic demand for
goods and services and via its effect on the exchange rate.
• When the interest rate falls, it is less profitable for households to save,
and they will therefore increase their consumption.
• Borrowing also becomes less costly.
• The interest rate helps guarantee that current savings will flow into
investment to promote economic growth.
• It rations the available supply of credit, generally providing loanable funds
to those investment projects with the highest return.
• It brings the supply of money into balance with the public’s demand for
money
• The interest rate serves as an important tool for government policy
through its influence on the volume of savings and investment

76. CONCLUSION
• Money supply and Money demand are the crucial factor in determining the
interest rate in the context of Nepal.
• Interest rates, in general, reflect the cost of funds- the interest rate can be
viewed as the rental price for money (opportunity cost for money).
• The movement of interest rates affects a financial institutions reported
earnings and book capital.
• Interest rates will be stable only when the economy, money market, loanable
funds market, and foreign currency markets are simultaneously in equilibrium.
• Finally the various tools and techniques can be used for the minimization of
interest rate risk such as interest rate swaps, interest rate caps n many other.