2043 Topic 2 Interest Rate _ Yield Curve - Topic 2 Interest...

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Topic 2 Interest Rate and the Yield Curve Chapter 5:Money and Capital Market – Rose and Marquis Interest rate An interest rate is the cost of borrowing money . it is the compensation for the service and risk of lending money . Without it, people would not be willing to lend or even save their cash, both of which require deferring the opportunity to spend in the present . But prevailing interest rates are always changing, and different types of loans offer various interest rates . If you are a lender, a borrower or both, it's important you understand the reasons for these changes and differences. Therefore the study of yield curve. Lenders and Borrowers i. Lenders The money lender takes a risk that the borrower may not pay back the loan. Therefore, interest provides a certain compensation for bearing risk . Coupled with the risk of default is the risk of inflation . When you lend money now, the prices of goods and services may go up by the time you are paid back, so your money's original purchasing power would decrease. Therefore, interest protects against future rises in inflation. A lender such as a bank uses the interest to process account costs as well. ii. Borrowers Borrowers pay interest because they must pay a price for gaining the ability to spend now, instead of having to wait years to save up enough money. For example, a person or family may take out a mortgage for a house for which they cannot presently pay in full, but the loan allows them to become homeowners now instead of far into the future. Businesses also borrow for future profit. They may borrow now to buy equipment so they can begin earning those revenues today. 1
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Banks borrow to increase their activities, whether lending or investing, and pay interest to clients for this service. Interest can therefore be considered a cost for one entity and income for another. Interest is the opportunity cost of keeping your money as cash under your mattress as opposed to lending. If you borrow money, the interest you have to pay is the cost of forgoing the opportunity to have the money in the present. Among the many industries affected by fluctuations in interest rates, real estate and banking are perhaps the most directly impacted. When interest rates increase, borrowing becomes more expensive , dampening consumer demand for mortgages and other loan products and negatively affecting residential real estate prices . Rising interest rates can also lead to increased default rates , as holders of adjustable rate debt find themselves faced with higher payments . Vendors of mortgage backed securities, which consist of bundled mortgages, will see their ability to monetize the securities lessens as a result of the deterioration of the quality of the underlying asset.
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