Financial institutions: Interest rates

Financial institutions are companies that provide financial services as intermediaries of financial markets. They are also known as banking institutions. Financial institutions can be distinguished broadly into two categories according to ownership structure. That is, commercial banks and cooperative banks.

Types of Financial institutions

The following are the three major types of financial institutions:

Depository institutions

These are deposit-taking institutions. They specifically accept and manage deposits. They also make loan, including banks, building societies, credit unions, trust companies, and mortgage loan companies

Contractual institutions

They are basically insurance companies and pension funds.

Investment institutions

They include institutions such as investment banks and underwriters. they also cover other different types of financial institutions managing investments.

Interest rate on a security

Interest rate securities are a class of investment where, essentially, you lend money to an institution which pays you interest for a period of time. Some loans are perpetual and you only get your money back by selling the loan to another investor. However, most of the products are for a fixed period of time.

Types of interest rates on a security

There are different types of interest rates, such as, real, nominal, effective, and annual. They are distinguished by key economic factors. The factors can help individuals become better consumers and wise investors.

Nominal Interest Rate 

The nominal interest rate is the stated interest rate of a bond or loan. It signifies the actual monetary price borrowers pay lenders to use their money. This is also referred to as the coupon rate.

Real Interest Rate

The real interest rate is known as it factors inflation into the equation. Hence gives investors a more accurate measure of their buying power. That is, after they redeem their positions.

Effective Interest Rate

Investors and borrowers should also be aware of the effective interest rate. It takes the concept of compounding into account. The difference between the nominal and effective rates is, it increases with the number of compounding periods within a specific time period.

Factors that affect nominal rates on a security

The following are six factors that determine the nominal interest rate on a security:

  • real risk-free rate,
  • default risk,
  • maturity risk,
  • liquidity risk,
  • premium for expected inflation
  • quoted rate on a risk-free security.

Theories that explain the future yield curve of interest rates.

The following are the 3 theories that determine the yield curve of interest rates:

  • The expectation theory
  • Liquidity preference theory
  • Institutional or hedging pressure theory


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