Interest rate
The percentage a lender charges a borrower for the use of money for a period of time — the cost of debt to the borrower and the return to the lender, and never a single number for the whole economy.
In plain language
Debt is an "I owe you". Mr A borrows money from Mr B for a while and promises to pay it back with something extra for the favour. That something extra, as a percentage of the amount borrowed and per year, is the interest rate.
The workbook's own shorthand: if Mr A borrows "X" and must return "X + delta", then delta equals X times the rate R, times the fraction of a year the loan runs. R is the interest rate. It is the cost of debt for the borrower and the rate of return for the lender.
Here is the trap. "The interest rate is 6%" tells you almost nothing on its own. A housing loan, a personal loan and a five-year government bond can all sit at different rates on the very same day, because the rate depends on who is borrowing, for how long, and how safe the loan is.
How it works
The workbook's own comparison table makes the point directly: a housing loan up to Rs 50 lakh for 15 years at 6% p.a., a personal loan of the same size and term at 7% p.a., the same housing loan stretched to 20 years at 6.5%, and the same 15-year housing loan above Rs 50 lakh at 6.25%. Same borrower type, same broad purpose, four different rates — because tenor, amount and credit risk each move the price of money.
Macro factors the workbook lists as driving interest rates economy-wide: demand for money (rises with economic activity), supply of money (controlled by the central bank), the fiscal deficit and government borrowing, inflation, global interest rates and exchange rates, and central bank policy actions such as the repo rate.
Micro factors affecting the rate on one particular bond: maturity or tenor (longer tenor, generally higher rate), credit risk, seniority of the bond, whether it is secured, its liquidity, and investor sentiment.
One working example from the borrowing formula: if Mr A borrows Rs 100,000 for three months at R = 8% per annum, the extra he owes is delta = 1,00,000 × 8% × 3/12 = Rs 2,000, so he repays Rs 1,02,000 at the end of the three months.
A worked example
Mrs Iyer wants a Rs 40,00,000 loan for 15 years. Her bank quotes her 6% p.a. for a home loan against the same property, but 7% p.a. if she instead takes it as an unsecured personal loan for the identical amount and tenor — exactly the pattern the workbook's own table shows.
On the home loan route, one year of simple interest on the full principal would be 40,00,000 × 6% = Rs 2,40,000; on the personal loan route it would be 40,00,000 × 7% = Rs 2,80,000 — a Rs 40,000 difference for the same borrower, the same year, the same amount, purely because the loan is secured against the house in one case and not in the other.
If the central bank then raises its policy repo rate to fight inflation, both her home loan (if floating) and fresh personal loans will typically reprice upward together, because a policy rate move flows through to money market rates and then to bank lending rates — one of the workbook's named macro factors in action.
Why NISM asks about it
Chapter 1 (Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Market), section 1.1, opens the whole paper with this concept before moving to fixed income securities, term structure and bond valuation in the rest of the chapter. Expect a question that gives several rates for different loan types and asks which factor (tenor, amount, security) explains the difference, and a question listing macro or micro factors that move interest rates.
Common exam traps
- There is no single "the interest rate". The workbook stresses interest rate is subjective — it depends on tenor, amount and credit risk, even for the same borrower.
- Do not confuse the macro factors (demand and supply of money, fiscal deficit, inflation, global rates, central bank action) with the micro factors (maturity, credit risk, seniority, security, liquidity, sentiment). A question naming one list will test whether you can place its items correctly.
- Interest rate risk is the uncertainty in the movement of rates, not the rate itself — the workbook is explicit that both a rise and a fall affect participants, just in opposite directions.
- This page is the general concept. For the compounding effect on a stated rate, see effective interest rate; for the rate stripped of inflation, see real interest rate; for the rate with no credit risk at all, see risk-free rate.
Check yourself
1.Which of the following is listed in the workbook as a MICRO factor affecting the interest rate of a fixed income security, rather than a macro factor affecting rates across the economy?
- a)Seniority of the bond in the repayment hierarchy
- b)Fiscal deficit and government borrowing
- c)Global interest rates and foreign exchange rates
- d)Supply of money controlled by the central bank
Show the answer
Answer: (a) Seniority of the bond in the repayment hierarchy
The workbook splits the drivers into two lists. Macro factors (whole economy): demand for money, supply of money, fiscal deficit and government borrowing, inflation, global interest rates and forex rates, and central bank actions. Micro factors (specific to one security): maturity/tenor, credit risk, seniority of bonds, security of bonds, liquidity of bonds, and investor sentiment. Seniority — the order in which bondholders get paid if the issuer defaults — attaches to the individual instrument, so it is a micro factor.
2.A bond carries a nominal interest rate of 7% while the rate of inflation is 9%. Using the approximation the workbook gives for low-level rates, what is the real interest rate?
- a)Approximately −2%
- b)Approximately +2%
- c)Approximately +16%
- d)Approximately +0.63%
Show the answer
Answer: (a) Approximately −2%
The exact relationship is (1 + r) × (1 + i) = (1 + R), where r is real, i is inflation and R is nominal. For low-level rates this approximates to real = nominal − inflation = 7% − 9% = −2%. The workbook uses this exact example to make its point: if the rate of inflation exceeds the coupon rate of a bond, the real interest rate is negative. The investor's balance grows on paper while their purchasing power shrinks — which is exactly what Indian FD holders experienced in 2020–2022.
3.When the market interest rate rises, what happens to a coupon bond's price risk and reinvestment risk respectively?
- a)The bond price falls but reinvestment income rises
- b)The bond price rises and reinvestment income also rises
- c)The bond price falls and reinvestment income also falls
- d)The bond price rises but reinvestment income falls
Show the answer
Answer: (a) The bond price falls but reinvestment income rises
Price risk and reinvestment risk always work in opposite directions. If the market rate rises, the bond price falls (future cash flows are discounted at a higher rate, giving a lower present value), but the reinvestment income rises, because interim coupons are now reinvested at a rate higher than the original. If rates fall, the mirror applies: price rises, reinvestment income falls. The workbook adds a timing point worth remembering — the change in bond price is instant after the rate change, but the effect on reinvestment income is slow, spread over time.
Where this is taught
Free preparation for NISM Series IVRelated terms
- Effective interest rateThe rate actually earned over a year once compounding within the year is counted — always at or above the quoted nominal rate, and equal to it only when interest is paid once a year.
- Fisher effectThe proposition that, other things equal, a rise in expected inflation raises the nominal interest rate — which is why interest rate derivatives are the household sector's instrument for hedging inflation.
- Real interest rateThe nominal rate adjusted for inflation — what the lender actually gains in purchasing power, and a number that turns negative whenever inflation runs above the coupon.
- Risk-free rateThe rate on a sovereign borrowing in its own currency, where credit risk is absent because the government can print the money — the benchmark every other valuation is measured against.
- Term structure of interest ratesInterest rate plotted against term — one curve per credit quality, with the risk-free curve as the base and every other borrower quoted as a spread over it.
- All India Financial InstitutionsA named group of four RBI-regulated development institutions — Exim Bank, NABARD, NHB and SIDBI — treated as non-retail users for IRD participation and given their own, wider window for issuing Certificates of Deposit.