It is not possible for a financial
system to exist without the concept of interest rates. They are needed to
determine the cost of borrowing, return on investment, and are an essential component
of the total return on investments. Some interest rates allow analysts to
determine the future of the economy. Interest rates are used by the monetary
authorities as monetary tools. (Leeds, Von Allmen, & Schiming, 2006). While
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 an
entire financial system without interest rates.
It is inconceivable
for an economy to have no time value of money. The idea, underlying the time
value of money, is that a tangible sum of money received today is worth more
than the same amount of money received in future. Time value of money is an crucial concept in
an economy as it is affected by unavoidable economic concepts such as
inflation, which reduces the value of money over time. In turn, time value of
money is a concept applied when making investments and many other financial
decisions that involve future repayment or returns. (Shim & Siegel, 2008).
There are a few factors that can influence interest rate
changes, one of them being 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 factors that influence change are how
the strength of the economy impacts supply and demand of funds, fiscal policy,
and expectations of inflationary levels (Leeds, Von Allmen, & Schiming,
efficient market hypothesis argues that financial markets integrate all
information available in the public domain and that stock prices reflect all
the relevant information. With this understanding, stock prices are considered 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 weak in several aspects.
The problem with the hypothesis is that it 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.
Because investor values stocks differently, it is not possible to determine the
value of a stock under an efficient market (Harder, 2008). Under EMH, no
investor should be able to make more off an investment as someone else making
an equal investment. This is because their ownership from investment is equal
and neither has access to information regarding their investment that the other
doesn’t have. As we have seen, however, this isn’t necessarily true in practice
because there is a wide range of returns on investments achieved by a universe
of investors, investment funds and so on (Harder, 2008).