Effects of Interest Rate Change

 

Effects of Interest Rate Change- The Central Bank usually raise interest rates when inflation is prophesied to rise above its inflation target. Higher interest rates tend to reduce economic growth. Higher interest rates raise the cost of borrowing, reduce disposable income, and therefore limit the increase in consumer spending. Higher interest rates tend to decrease inflationary pressures and cause an appreciation in the exchange rate. When interest rates change, there are real-world effects on the ways that consumers and businesses can access credit to make necessary purchases and plan their finances. It even affects some life insurance policies. 

Change in the interest rate has certain effects on a bank with regard to various risks.

• Basis risk: assets and liabilities are based on different rates moving in a different direction
• Yield curve risk: bank earnings by taking advantage of difference in the short term and long term rates do not follow the market expectancy principle
• Reinvestment risk: related to the cost of capital of the bank, like a bank can borrow when rates are high, but when it lends prevailing rates become low
• Option risk: prepayment options associated with a loan, similar to a putable bond

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