It is not possible for a financial
system to exist without the concept of interest rates. Interest rates are one of the most crucial
aspects of the financial system. They
are used to determine the cost of borrowing, the return on investment, and are
also an integral constituent of the total return on most investments. In addition, some interest rates give
insights into the future of financial markets and the economy. In addition,
interest rates are used as monetary tools by the monetary authorities (Leeds,
Von Allmen, & Schiming, 2006).
Although it is possible to operate banking system without the concept of
interest rates, as it happens in Islamic banking (Saeed, 2010), it is not
possible to run the entire financial system without interest rates.
inconceivable to have an economy which has no time value of money. The concept
underlying the time value of money is that a given sum of money received today
is more than the same amount of money received in future. Time value of money is an indispensable
concept in an economy because it is influenced by inevitable forces in the
economy such as inflation, which reduces the value of money over time.
Accordingly, time value of money is applied in making of investments and all
financial decisions that involve arrangements to make or receive payment in the
future (Shim & Siegel, 2008).
Change in interest rates can be influenced by a host of
factors. One of the factors underlying change in interest rates are actions of
the monetary authority. For example, in
the United States, the FED can cause interest rates to rise or fall by selling
or buying treasuries respectively. Other key factors that influence change in
interest rates include the strength of the economy impacts supply and demand of
funds, fiscal policy, and expectations of inflationary levels (Leeds, Von
Allmen, & Schiming, 2006).
efficient market hypothesis argues that financial markets integrate all
information available in the public domain and that stock prices reflect all
the relevant information. Accordingly,
stock prices are accurate in average,
meaning that markets are efficient and no active investor can beat the market
by taking advantage of any public
information (Harder, 2008). The efficient market hypothesis is, however,
faulted for being weak in several aspects.
The hypothesis assumes that all investors view all available information in precisely
in the same way. However, the many
techniques of analyzing and valuing stock curtail the validity of EMH. For
example, if one investor is looking for an undervalued market opportunity and
another one assesses a stock on based on its potential for growth, the two
investors will arrive at a different evaluation of the fair market value of the
stock. Thus, because investor values
stocks differently, it is not possible to ascertain the value of a stock under
an efficient market (Harder, 2008).
Furthermore, under EMH, no investor should be able to make greater
earning that another with equal
investment amounts because the fact that they have equal possession of
information implies that they can only achieve similar returns. However, this
is not true in practice, as it is evident that there is a wide range of returns on investments achieved by a
universe of investors, investment funds and so on (Harder, 2008).