It is not possible for a financialsystem to exist without the concept of interest rates. They are needed todetermine the cost of borrowing, return on investment, and are an essential componentof the total return on investments. Some interest rates allow analysts todetermine the future of the economy.
Interest rates are used by the monetaryauthorities as monetary tools. (Leeds, Von Allmen, & Schiming, 2006). Whileit 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 anentire financial system without interest rates. It is inconceivablefor an economy to have no time value of money. The idea, underlying the timevalue of money, is that a tangible sum of money received today is worth morethan the same amount of money received in future. Time value of money is an crucial concept inan economy as it is affected by unavoidable economic concepts such asinflation, which reduces the value of money over time. In turn, time value ofmoney is a concept applied when making investments and many other financialdecisions that involve future repayment or returns. (Shim & Siegel, 2008).
There are a few factors that can influence interest ratechanges, one of them being actions of the monetary authority. For example, inthe United States, the FED can cause interest rates to rise or fall by sellingor buying treasuries respectively. Other factors that influence change are howthe strength of the economy impacts supply and demand of funds, fiscal policy,and expectations of inflationary levels (Leeds, Von Allmen, & Schiming,2006). Theefficient market hypothesis argues that financial markets integrate allinformation available in the public domain and that stock prices reflect allthe relevant information.
With this understanding, stock prices are considered accuratein average, meaning that markets are efficient, and no active investor can beatthe market by taking advantage of any public information (Harder, 2008). Theefficient market hypothesis is weak in several aspects. The problem with the hypothesis is that it assumes thatall 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 thevalue of a stock under an efficient market (Harder, 2008). Under EMH, noinvestor should be able to make more off an investment as someone else makingan equal investment. This is because their ownership from investment is equaland neither has access to information regarding their investment that the otherdoesn’t have. As we have seen, however, this isn’t necessarily true in practicebecause there is a wide range of returns on investments achieved by a universeof investors, investment funds and so on (Harder, 2008).