Question

1. Define interest and explain how interest rates vary based on risks, maturity, loan size and taxability.

Answer 1

Interest refers to the amount of money paid due to the use of money borrowed from the lender. It is paid at a rate and that rate is called as interest rate.

Regarding risk, interest rate varies as with increase in risk, interest rate increases and vice versa. It happens, because risk premium is added to the interest rates.

Regarding maturity, there is a higher interest rate for longer period of maturity in comparison to the short term maturity. It is due to the higher interest rate risk associated with a longer period of maturity.

Higher loan size, increases financial risk and it causes interest rate to increase and vice versa.

Taxability or tax benefits also affect the interest rate. A benefit of a tax gain, makes interest rate to be lower than those instruments who do not give tax shield advantage.