Course Hero Logo

Interest Rates

Supply and Demand in Investment Markets

Securities markets are governed by supply and demand.

In manufacturing markets, the economic supply-and-demand model follows the basic principle that a consumer demands a product and a manufacturer supplies that product. While manufacturing markets are delicately balancing the amount of supply to meet the demands of the consumer, prices often fluctuate. The manufacturer hopes to achieve equilibrium for optimal performance. Equilibrium is the point at which the supply of currency meets the demand for that currency. Comparatively, in the arena of finance and interest rates, when a consumer purchases a product such as an automobile or house, they are often required to obtain a loan to fund the product. After receiving the loan, consumers must pay the principal amount and a rate of interest that is applied to the remaining amount to pay. An interest rate is the amount due per period, as a percentage of the amount owed by the borrower to the lender at the end of the previous period. Interest rates are generally expressed as an annual percentage. An interest rate for loans can be calculated using either simple or compound interest. Simple interest is an interest rate multiplied by the initial payment. Compound interest is a form of calculating interest in which the interest rate is multiplied by the sum of any remaining unpaid principal and unpaid cumulative interest, as of the previous period.

Banks often use a simple interest formula, and credit cards use a compound interest formula. For example, if the bank is offering a loan of $10,000 loan with a 10 percent interest rate using simple interest, the interest is $10,000×10%=$1,000\$10{,}000\times10\%=\$1{,}000. After 5 years, this is $5,000. Credit cards roll this amount back into the loan as compound interest. For the same loan terms, the borrower would pay $6,105 in interest.
Compound Interest=$10,000(1+0.10)5=$16,105$10,000=$6,105\begin{aligned}\text{Compound Interest}&=\$10{,}000\;(1+0.10)^5\\&=\$16{,}105-\$10{,}000\\&=\$6{,}105\end{aligned}

Supply and Demand for Securities

Securities follow the rules of supply and demand. The supply and demand changes as the price makes it more attractive. There is a shift in supply as the price changes.
In finance, supply and demand meet the consumer's needs, but instead of purchase price, the interest rate is the variable. As with manufacturing, in order to gauge when to invest, investors are looking for the rate when the demand for money equals the supply of money, or the equilibrium interest rate. For example, Cogs Inc. needs to raise capital, so it issues 1,000 bonds at a rate of 10 percent. This rate of return is higher than most investors require, making the demand for the bond high. Because the supply is fixed at 1,000 and the demand is high, the value of the bond will be higher than if supply and demand were at equilibrium.

With all loans there is a level of risk in whether or not a loan will be paid back in full. Some institutions desire to sell their loans to other parties, such as a dealer system, to reduce or eliminate risk potential. A dealer system is a practice in which loans are sold to a financial institution or third party as part of the sale of securities. Loanable funds are the total amount of funds that all individuals and institutions supply to borrowers, and the loanable funds theory explains the processes that might attract an investor.

A local bank relies on loanable funds to generate income through interest rates. The interest rate is the cost of money. Where supply is short, money becomes more expensive due to rising interest rates. During the buying and selling process, the interest rate drives decision-making. An investor or secondary market will buy loans using the loanable funds theory. The loanable funds theory is the belief that the interest rate is established by the supply and demand of loanable funds in the marketplace. During this process the investor desires a return on their investment and will use the supply-and-demand model of interest rates to make their purchase determination.