Page 33 - Banking Finance July 2020

ARTICLE

retail loans. This rate is directly linked to repo rate to pass plate of Samosas will be Rs 10.50/-. So he can buy 1019 plate
on the benefits of rate cut by RBI to the consumers promptly. of Samosas i.e. the purchasing power has increased in 2nd
case where he can buy 19 more quantities than the previous
Let us understand this with an example. We assume that one.
repo is 4.5%, spread is 3.5% and premium is 1.5% for an
MSME loan of Rs. 10.00 lakh then How interest rates work in fixed income
EBLR = Repo (4.5) + Spread (3.5) =8% security/bond market:
Where spread depends upon the operating cost and capital A bond is a debt instrument in which an investor loans
charge money to an entity (typically corporate or government)
Offered Card Rate = EBLR (8) + Premium (1.5) = 9.50% which borrows the funds for a defined period of time at a
variable or fixed interest rate. Bonds are used by companies,
Banks reset these benchmark rates time to time and the municipalities, states and sovereign governments to raise
card rate for a borrower, who has availed floating rate of money to finance a variety of projects and activities. Owners
interest will also changes. of bonds are debt holders, or creditors.

If lending rates changes then to make balance between As we already learned during our discussion of repo,
asset and liability, banks reset the deposit's rates accordingly government or RBI issues such bonds and sells them in the
and vice versa. marked like Govt. Securities (G-Sec), State Development
Loans (SDL), Treasury Bills etc. to raise money and buy them
What rates actually customers are back as well. These securities are issued with a coupon rate
and a fixed maturity. Coupon rate is a rate, which is paid on
getting - Nominal Vs Real Interest rate: the face value of the bond on half yearly or yearly basis till

Nominal interest is the card rate which customers are the maturity. When buying a bond, the investor should also
offered by bank and the real interest rate is nominal interest look into another aspect i.e. yield to maturity (YTM) which
rate minus inflation i.e. the rate after taking into is also called interest rate in case of bonds. This interest rate
consideration the time value of money or the purchasing determined as the equation given below.
power of the consumer.
Interest Rate = Risk free rate + Inflation Premium + Default
Let us understand this with an example. 9% offered on Risk Premium + Liquidity Premium + Maturity Premium
deposit in 2011 or 7% in 2019, which rate is better? The
quick answer is of course 9% in 2011. But wait for a second, So this yield keeps on changing depending upon various
is this so simple. No, this is not so simple and the reason is macro-economic factors. Then the price of the bond is
inflation. Let us assume that the inflation were 9% and 5% determined by discounting all the future inflows till maturity
in the year 2011 and 2019 respectively. So the real interest from the bond by the interest rate or the YTM. So an
rates come to 0% and 2% after making the inflationary upsurge in the yield results into drop in bond price. We can
adjustments to the nominal rates. also see that ceteris paribus, a high inflation results into
higher interest rate and lower bond prices.
Suppose a depositor is having Rs. 10000/-savings and he
deposited it in a bank for one year. He just loves to eat Let us understand this with a small example. Suppose a
Samosas and will buy Samos as with the matured amount. government bond with 1 year maturity, face value of Rs 100/
Now we assume that the rate of Samosas is Rs. 10/- per - and coupon of 8% issued on 01.01.2020 which pays the
plate now. So with 9% interest he will receive Rs. 10900/- coupon yearly. Now on 01.07.2020 the yield is 10%. We will
after maturity and the price of one plate of Samosas will get Rs 108/- on maturity of the bond with 8% coupon rate.
be Rs 10.90/-. So he will be able to buy 1000 plates of If we discount Rs 108/- by 10% i.e. a discounting factor 0.1,
Samos as with money. Now in the second case with 7% we get Rs 98.18/- so the price of the bond goes down to Rs.
interest rate he will receive Rs 10700/- and the price of one 98.18/- from Rs 100/- when yield goes up from 8 to 10.

BANKING FINANCE | JULY | 2020 | 33