Factors of Interest Rates

Interest rate represent the cost of money. For long term (more than one year) financing, standard banking practice is to use the nominal rate to calculate the interest payments on the outstanding or declining balance of a loan. 

The most important issue affecting the imputation of future cash flows lies in our judgement about the extent to which savings and current accounts can be portrayed as long term liabilities. In practice, banks all over the world have observed that these deposits have longer effective maturities or reprising periods (Houpt & Embersit 1991). To the extent that these liabilities prove to be long dated, banks would be able to buy long dated assets, and earn the long-short spread, without incurring interest rate expose.

The extent to which savings and current deposits would move when interest rate changed is a behavioral assumption, and alternative assumptions could have a significant impact upon our estimates of interest rate risk.

We have a scenario tilted RBI, which uses RBI’s requirements for the interest rate risk statement. It involves assuming that 78% of savings deposits are “stable”, and that these have an effective maturity of three to six months. This appear to be an usually short time horizon, gives (a) a strong stability of savings account and (b) the long time till modification of the savings bank interest rate in India. RBI suggests that 100 % of current account should consider volatile.

Let us see how the rate of interest depend on several parameters: