Risk of Default or Non-Payment
Lender seeks higher compensation for higher risk of default.
Credit standing of borrower affects the rate of interest. Business having good credit rating may be able to borrow at lower rate than business having poor credit rating.
Level of Gearing
Interest rate depends on level of gearing at the time of debt issue. High level of gearing implies higher financial risk. Therefore, interest rate payable on debt issued at higher level of gearing will be higher than interest rate payable on debt issued at lower level of gearing.
Spread on Interest Rate
Financial intermediaries such as banks earn profits by borrowing at lower interest rate from suppliers and lending at higher interest rate to customers. Financial intermediaries seeking to increase their profit by increasing their spread will results in higher interest rate to borrowers and lower interest rate to lenders.
Size of Loan
Large amount of borrowing may result in lower interest rate than small amount of borrowing because of reduction in transaction cost per currency unit. Similarly, large of amount of deposit may result in higher interest rate than small amount of deposit because of reduction in transaction cost per currency unit.
Flexibility & Marketability
Interest rate depends on ability of investor to withdraw deposits without incurring penalty or ability to withdraw part of the investment without losing entitlement to receive interest on remaining amount.
Interest rate also depends on ability to sell their investment to other investors in the market.
Liquidity Preference Theory
Liquidity preference theory states that investors prefer to receive their investment back as earlier as possible.
Long-term loans bear the higher risk of default than short-term loans. Lender needs compensation for higher risk through higher interest rate. Long-term loans are more costly for borrower and more profitable for lenders than short-term loans.
Reason for borrowing long-term loan is the certainty of having finance available without being exposed to risk of failure to borrow again.
Expectation Theory
Expectation theory states that forward interest rate depends on expectations of movement in interest rate.
If interest rate is expected to rise in future, then interest rate on short-term borrowings will be lower than interest rate on long-term borrowings. It means yield curve will be in upward direction.
If interest rate is expected to fall in future, then interest rate on short-term borrowings will be higher than interest rate on long-term borrowings. It means yield curve will be in downward direction.
Market Segmentation Theory
Market segmentation theory states that most of the investors do not change their investment behaviour. Investors participating in short-term market will not move to long-term market and investors participating in long-term market will not change to move to short-term market.
It means that expectations and liquidity preference does not affect interest rate movements and interest rate is dependent upon supply and demand for capital in individual market segments. Yield curve reflects market conditions in individual market segment rather than expectations and liquidity preference.
Government Policy
Government policy of keeping interest rates temporarily low in the short term will result in higher interest rate in long term than in short term. Yield curve will be in upward direction.
Government policy of keeping interest rates temporarily high in the short term will result in lower interest rate in long term than in short term. Yield curve will be in downward direction.
