Interest Rates

Interest rates are the price that one pays to use money that belongs to others. Since money can be borrowed for short or long term needs and can be borrowed under high or low risk conditions, the price one must pay to borrow it, or is entitled to receive to lend it, is a variable. This variable depends on the conditions of risk and expected return, as well as the normal price determinants of supply and demand of money available in worldwide market.

For example, the Government of the United States, because it has the power to tax the wealthiest population on the planet and has over two hundred years of credit history and stable government, is regarded as the most credit worthy borrower in the world. In addition, and perhaps because it enjoys such a unique position, the U.S. Government is one of the world's largest borrowers both in terms of the volume that it borrows and the frequency of its borrowings. It borrows from any lender in the world and in three modes: short, intermediate and long term, and at public or dealer auction. Its short term borrowings, called treasury bills, are normally issued for 90 days and are sold weekly at public auction. This weekly 90 T-bill rate is called the risk free rate (rf), and it is regarded as the world standard interest rate. Why? No knowledgeable investor would lend to any person or organization at a rate lower than what the Government of the United States would pay to borrow for 90 days.

Therefore all prices for money denominated in American currency begin with the risk free rate and increase in proportion to the time and risk to which the borrowed money is exposed. Even the United States government has to pay more to borrow for a longer term than 90 days to compensate the lender for the erosion of value that takes place from inflation over time. As such, one can find a daily graph in the financial press on what it costs the Government to borrow money for 90 days up to what is called the "long bond" which the Government uses to borrow money for 30 years. This chart is called a yield curve chart and is widely used by analysts to forecast interest rates and inflation trends.

Interest rates for other levels of risk, such as mortgages, car loans, and business loans of various kinds, are a function of how risky they are compared to the risk free rate, and to each other. Indeed, worldwide rates for money are in some measure geared to the T-bill rate our Government is willing to pay.

The major role government plays in the cost of borrowing funds also affects equity markets worldwide. Investors want additional compensation over the lending rates for providing permanent capital to the world financial markets.

The Federal Reserve operations of our Government also control the supply of dollars available to the system. The Fed regulates the interest rates that banks can pay to borrow from other banks, or from the Fed itself, and the Fed can regulate the amount of Government bonds outstanding.

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