It is not possible for a financialsystem to exist without the concept of interest rates. Interest rates are one of the most crucialaspects of the financial system. Theyare used to determine the cost of borrowing, the return on investment, and arealso an integral constituent of the total return on most investments. In addition, some interest rates giveinsights 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 ofinterest rates, as it happens in Islamic banking (Saeed, 2010), it is notpossible to run the entire financial system without interest rates. It isinconceivable to have an economy which has no time value of money. The conceptunderlying the time value of money is that a given sum of money received todayis more than the same amount of money received in future.
Time value of money is an indispensableconcept in an economy because it is influenced by inevitable forces in theeconomy such as inflation, which reduces the value of money over time.Accordingly, time value of money is applied in making of investments and allfinancial decisions that involve arrangements to make or receive payment in thefuture (Shim & Siegel, 2008). Change in interest rates can be influenced by a host offactors. One of the factors underlying change in interest rates are actions ofthe monetary authority. For example, inthe United States, the FED can cause interest rates to rise or fall by sellingor buying treasuries respectively.
Other key factors that influence change ininterest rates include the strength of the economy impacts supply and demand offunds, fiscal policy, and expectations of inflationary levels (Leeds, VonAllmen, & Schiming, 2006). Theefficient market hypothesis argues that financial markets integrate allinformation available in the public domain and that stock prices reflect allthe relevant information. Accordingly,stock prices are accurate in average,meaning that markets are efficient and no active investor can beat the marketby taking advantage of any publicinformation (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 preciselyin the same way. However, the manytechniques of analyzing and valuing stock curtail the validity of EMH. Forexample, if one investor is looking for an undervalued market opportunity andanother one assesses a stock on based on its potential for growth, the twoinvestors will arrive at a different evaluation of the fair market value of thestock.
Thus, because investor valuesstocks differently, it is not possible to ascertain the value of a stock underan efficient market (Harder, 2008). Furthermore, under EMH, no investor should be able to make greaterearning that another with equal investment amounts because the fact that they have equal possession ofinformation implies that they can only achieve similar returns. However, thisis not true in practice, as it is evident that there is a wide range of returns on investments achieved by auniverse of investors, investment funds and so on (Harder, 2008).