What Really Determines the Rate of Interest? INTRO: Some interest rates are low, some high. We all watch interest rates as they affect us in many ways. What really goes into the determination of how interest rates are set? Here to help us understand the basic makeup of rates is Bruce Hagan, certified financial planner with RAI Investments and Corporate Securities Group. Q1. Bruce, starting with the very basics, exactly what are interest rates and how are they set? A1. Interest rates are simply the price of funds available for borrowing and lending. And we need to think of interest rates in terms of price, as we would the price of bread or gasoline or anything else. As with other prices the interest rate is set by forces of supply and demand. The equilibrium interest rate, or price of loanable funds, is the one at which the quantities of such funds demanded and supplied are equal. Q2. Now in reality there are many interest rates, not just one. Are there similar factors that affect all interest rates? A2. Generally, yes and we start with the real risk-free rate of interest, which is the return an investor could earn in a riskless, inflation-free environment. Wherever the forces of supply and demand would price that rate is our starting point and we add on from there? Q3. What do you mean by add-ons? A3. Well first we have to add-on an inflation premium to compensate the investor (or loaner) for the expected annual loss of purchasing power due to inflation. Q4. O.K., so inflation has made our basic interest rate more expensive. A4. Right! And now we have to add-on the default premium to compensate the investor for the risk that the borrower may fail to repay the loan on a timely basis. Q5. That’s two, are there other add-ons? A5. The next is the liquidity/marketability premium which compensates the investor for the risk of possibly not being able to sell the loan (or bond) at the original cost. Q6. What about the length of the loan? A6. Another very important add-on. There is more uncertainty associated with a long duration loan than with a short-duration loan. Over a long time a multitude of unforeseen problems could arise and the investor must be compensated for that risk. Q7. So are these add-ons present in interest rates to varying degrees? A7. Correct. Take the default add-on, for example. If you were to invest $10,000 in a bond issued by a Fortune 500 company with a strong balance sheet and high S&P rating, the add-on would be much lower than if you took that same $10,000 and loaned it to an acquaintance who was going to open a new restaurant. You must be compensated for the higher risk of default bey receiving a higher interest rate. The discussion offered above and in the movie should not be considered an endorsement by Florida State University. They are offered in the educational sense of providing thought-provoking information for our Web audience. Copyright shared with Florida News Channel (FNC), all rights reserved. Broadcast 2/12/99