What is interest rate?

In financial markets, there is a cost associated with using funds, known as the cost of capital. The interest rate represents this cost of capital.

For example, if we take out a bank loan of 1 million with an annual interest rate of 5%, this 5% is the cost we pay for using the bank's funds. The 1 million borrowed this year will require repayment of 1.05 million next year.

In financial markets, interest rates guide the flow of capital to where it can be most efficiently utilized. For instance, when businesses have many profitable projects during a certain period but require funding, they can attract investors' capital from elsewhere by offering higher interest rates.

The price of goods is determined by supply and demand. In financial markets, money is also a commodity, and interest rates are determined by the supply and demand of funds. For example, when people deposit more money in banks while fewer businesses take out loans, banks will have excess funds, leading to lower deposit rates. Conversely, when fewer people deposit money while businesses seek loans, banks will raise interest rates to attract deposits due to fund shortages.

Components of Interest Rates:

Bank loan rates vary by individual, and deposit rates differ by term. For example, a 1-year deposit may carry a 4% annual rate while a 3-year deposit offers 6%. How are these rate differences determined?

Interest rate differentials stem from their composition, which mainly consists of three parts:

1. Pure interest rate (time value of money), typically represented by risk-free rates like government bond yields;

2. Inflation rate - when prices continuously rise, both depositors and lenders must account for inflation;

3. Default risk premium - banks demand compensation for the risk of loan defaults.

Central banks directly adjust policy rates. When economic conditions fluctuate, central banks may raise or lower rates to restrain or stimulate the economy, thereby influencing market rates. In the long run, interest rates are ultimately determined by market supply and demand.

Impact of Interest Rates on Financial Markets:

Interest rates affect the entire macroeconomy. Nearly all financial phenomena and assets are connected to interest rates in some way.

1. Interest Rates vs Inflation

Central banks use interest rates to influence inflation. Raising benchmark rates increases banks' lending costs while boosting depositors' interest income, reducing demand and causing prices to fall, thereby lowering inflation. Conversely, rate cuts stimulate consumption, increasing demand and prices, leading to inflation. Moderate inflation benefits the economy, but excessive inflation is harmful.

2. Interest Rates vs Bonds

When rates rise, bond returns may become less attractive than savings accounts, reducing demand and causing bond prices to fall. Bond investors may demand higher returns as risks increase. When rates fall, fixed bond yields become more appealing, increasing demand and pushing bond prices higher.

3. Interest Rates vs Stocks

Higher rates encourage saving over spending on goods/services, reducing corporate profits and stock prices. Lower rates decrease corporate funding costs, boosting profits. Increased consumer spending further lifts corporate earnings, making stocks more attractive to investors and driving share prices up.

4. Interest Rates vs Exchange Rates

Higher interest rates increase a currency's appreciation potential, lowering import costs in domestic currency terms while raising them in foreign currencies. Lower rates make currency depreciation more likely.

As a crucial financial variable in economics, interest rates form the underlying transmission mechanism connecting nearly all financial phenomena and assets in ever-changing markets.