November 25, 2012

MA0042 [Treasury Management] Set2 Q3

Q.3 Explain loanable fund theory and liquidity preference theory.

Ans:

Here we will discuss about the theories on interest rate whose main focus is on the charged amount to be paid against the borrowed money. In every case the rate of interest is charged on the total asset values. Different types of interest terms exist in todays global economic environment which has its own identical meanings like simple interest, compound interest, fixed and floating rates of interest, cumulative interest or return.

The rate of interest in the global investment market is determined according to the existing conditions of the retail economic organisations like banks, bond market and financial market. Before calculating the rate of interest, each type of debt instruments in the market considers factors like inflation, opportunity cost, and interest rate risk.

There are various interest rate theories given by several economists like loanable funds theory, time preference theory, mathematical theory, classical theory of interest. Investment being a function of interest rates, the impact of interest rates on the economy is very significant. We will discuss few of the interest theories in the succeeding section.

Loanable funds theory
Loanable funds theory explains that the calculation of the rate of interest is on the basis of demand and supply of loanable funds which are available in the capital market. The concept was created by Knut Wicksell (1851-1926), who was a well-known Swedish economist. It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946).

An increase in the demand of loanable funds leads to an increase in the interest rate and vice versa. Also an increase in the supply of loanable funds results in the fall of interest rate. If both the demand and supply of the loanable funds changes, the resultant interest rate depends on the level and route of the movement of the loanable funds.

The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. The short-term interest rates are assessed on the basis of the financial conditions of an economy.

In case of loanable funds theory the determination of the interest rates depends on the availability of the loan amount. The availability of loan amount is based on certain factors like net increase in currency deposits, amount of savings made, and willingness to enhance cash balances.

Liquidity preference theory
The liquidity preference theory or liquidity preference hypothesis, proposed by J. M. Keynes, explains the relation between the generation of a debt instrument and its maturity period.

The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks, bonds and commodities. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments.

The liquidity preference theory does not deal with liquidity, but deals with the risks associated with maturity. According to this theory, the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period.

According to the liquidity preference theory, if the investors possess debt instruments that have longer term periods then they will receive a premium of the rates of interest over a long-term period. This premium is known as the liquidity premium. Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. As a result of the premium, the generation of the debt instrument that has a longer periodic term is higher compared to debt instruments having shorter term periods.

Liquidity preference is a potentiality or functional tendency, which arranges the quantity of money which the public will hold when the rate of interest is given; so if r is the rate of interest, M the quantity of money and L the function of liquidity preference, we can define M = L(r).

Cause of liquidity preference
Liquidity preference theory is preferred among most of the theories. The liquidity preference theory is a short-run model of interest rate determination. It describes economic fluctuations around the long-run drift. It provides a suitable analytical framework to investigate the role of monetary policy and the financial system. The liquidity preference theory also proposes the concept of risks and liquidity premium to predict the future rates.

Investors have a preference for investing in short-term securities. But, when the market interest rates change, the prices of long-term bonds fluctuate more than the prices of short-term bonds. The added risk prevents some investors from investing in long-term bonds. To attract investors, the long-term bonds must offer a return that exceeds the expected return on a series of short-term bonds. Therefore, when the yield curve rises up, we cannot be sure whether this is the result of investors expecting interest rates to rise in the future. The liquidity preference theory recognises this problem. It depicts that the yield curve slope is influenced by the expected interest rate changes and the liquidity premium that investors require on long-term bonds.

The following are the three divisions of liquidity preference:
Transactions motive It is the need of cash for the current transaction of personal and business exchanges.
Precautionary motive It is the desire for security as to the future cash equivalent of a certain proportion of total resources.
Speculative motive It is the object of securing profit from knowing better than the market what the future will bring forth.

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