INTEREST RATES –

Conventional and Islamic Perspective

Objectives

• The Time Value of Money

• The Term Structure of Interest Rates

• Money and Interest Rates

• Money and Inflation

• Islamic Perspective of Interest Rates (Riba)

• Islamic Alternatives to Interest Rates

Time value of money

• The primary objective of financial management is to maximize the value of the firm’s stock.

• The stock values depend on the timing of the cash flows investors expect to receive from an investment.

• A ringgit expected soon is worth more than a ringgit expected in the distant future.

• Therefore, it is essential for financial managers to have clear understanding of the time value of money and its impact on stock market.

Time line

Time0 1 2 3 4 5

Time 0 is today

Time 1 is one period from today, or the end of Period 1

Time 2 is two period from today, or the end of period 2

And so on….

Often the periods are years, but other time intervals such as semiannual periods, quarters, months, or even days can be used.

Example 1

Time 0 1 2 3 4 5 5%

-100 ?

•Here the interest rate for each of the three years is 5 percent.•A single amount (or lump sum) cash outflow is made at Time 0,•The Time 3 value is unknown inflow.•Since the initial $100 is an outflow (an investment), it has minus sign.•Since the Period 3 amount is inflow, it does not have a minus sign

Example 2

Time 0 1 2 3 4 5 5% 10%

-100 ?

•Here the interest rate is 5 percent during the first period, but it rises to 10 percent during the second period.•If the interest rate is constant in all periods, we show it only in the first period, but if it changes, we show all the relevant rates on the time line.

Future value

• A ringgit in hand today is worth more than a ringgit to be received in the future because, if you had it now, you could invest it, earn interest, and end up with more than one ringgit in the future.

• The process of going from today’s values, or present values (PVs), to future values (FVs) is called compounding.

Future Value: An example

Time 0 1 2 3 4 5 5%

-100 ?

•You deposit RM100 in a bank that pays 5 percents interest each year.FVn = FV1 = PV + INT

=PV + PV(i) =PV(1 + i) =RM100(1+ 0.05)= RM100(1.05)= RM105

PV = present value. Here PV=RM100i = interest rate. Here the interest rate is 5 percent, or

express as a decimal, i = 0.05INT = Ringgit or interest you earn during the year. INT = RM100 x 0.05 = RM100(0.05)= RM5n = numbers of periods involve in the analysis. Here

n=1.

FVn = FV1 = PV + INT =PV + PV(i) =PV(1 + i) =RM100(1+ 0.05)

= RM100(1.05) = RM105

Future Value: For 5 years

Time 0 1 2 3 4 5 5%

Initial Deposit -100 FV1=? FV2=? FV3=? FV4=? FV5=?

Interest earned 5.00 5.25 5.51 5.79 6.08

Amount at the end

of each period=FVn 105.00 110.25 115.76 121.55 127.63

How to count?

• The value at the end of Year 2 FV2= FV1(1+i)

= PV(1+i)(1+i) = PV(1+i)² = $100(1.05)²=$110.25

• The value at the end of Year 3FV3= FV2(1+i)

= PV(1+i)(1+i)(1+i) = PV(1+i)³ = $100(1.05)³=$115.75

The Equation of future value

FVn = PV(1+i)n

Present Value ? What is discounting process?

• The process of finding the present value of a cash flow, or a series of cash flows; discounting is the reverse of compounding.

• Suppose you have some extra cash, and you have a chance to buy a low-risk security that will pay $127.63 at the end of five years.

• Your local bank is currently offering 5 percent interest on five years certificates of deposit (CDs). Which one would you choose?

Present Value: An example

Time 0 1 2 3 4 5 5%

PV=? 127.63

FVn = PV(1+i)

PV= FVn

(1+i)

n

n

Understanding Interest Rates

• Interest rates receive a lot of attention in the media, but what are they, anyway?

• How are they determined?

• What do they do?

• This introduction provides some basic answers to these questions

What is Interest?

• Interest is the price that someone pays for the temporary use of someone else’s funds. To repay a loan, a borrower has to pay interest, as well as the principal, the amount originally borrowed.

• Interest is the compensation that someone receives for temporarily giving up the ability to spend money. Without interest, lenders wouldn’t be willing to lend, or to temporarily give up the ability to spend, and savers would be less willing to defer spending.

• Interest rates are expressed as percents per year. If the interest rate is 10 percent per year, and you borrow $100 for one year, you have to repay the $100 plus $10 in interest.

• Because interest rates are expressed simply as percents per year, we can compare interest rates on different kinds of loans, and even interest rates in different countries that use different currencies (yen, dollar, etc.).

Why does interest exist?From the lender’s point of view:• Interest compensates lenders for the effects of inflation,

or rising prices. Prices go up every year, so lenders are repaid with dollars that can’t buy as much as the dollars they lent; the lenders must be compensated for that loss of purchasing power.

• Interest also compensates lenders for the risks they take. One risk is that nobody knows for certain how much prices will go up during the time that the borrower has the lender’s money. Other risks are that the borrower won’t repay the loan fully, on time, or at all.

• For a lender such as a bank, interest covers the costs of staying in business, including the cost of processing loans, and interest also provides the profit that a lender needs to stay in business.

From the borrower’s point of view:• Individuals are willing to pay interest to borrow money in

order to be able to spend now, rather than later, on cars and many other items.

• Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own.

• Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability.

• Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits.

• Some borrowers are willing to pay interest on certain loans because of the associated tax advantages.

• Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit.