The enigmatic nature of interest rates

Everyone has a basic idea of what interest is. It's the percentage of the borrowed money that had to be paid each year as a cost for the privilege of borrowing. What isn't generally realised is that interest rates are the smoothed out average of chaotic activity. Interest rates are a kind of barometer, reflecting the current value of money and the state of the prevailing economic conditions. They are not decided by human agencies.

Many people think that interest rates are based upon some figure that is decided by a central bank or a government authority. This is a fallacy. Government agencies and banks are compelled to make official changes to interest rates by market forces. The basic determinant of interest rates is the current market value of money. This is not constant and is in a constant state of flux. Governments may change government policies to try to have an effect on the level of interest rates, but, they cannot control the level simply by changing its value - at least, not without causing all kinds of unpredictable problems.

Money is a commodity and like all commodities its value will fluctuate according to supply and demand. In time of economic expansion, money is in demand and interest rates rise. In times of depression demand falls off and interest rates fall with it. In boom times money can be used profitably and so a lender will ask for and get higher interest rates. Conversely, in times of recession, when profits are scarce, interest rates are low because money is not able to be used to create wealth so easily.

Money is available in the form of a large number of currencies. Each of these currencies will have a different value. Each currency value will vary against all other currencies as various different factors particular to each individual currency have an effect. These currency variations will be accompanied by different varying interest rates as each currency will have its own fluctuating demand and stability.

All kinds of miscellaneous factors will affect the value of currencies, wars, weather, disasters and catastrophes, political policies, availability of resources, etc. Any number of different factors can effect the value of money and cause interest rates to change.

Just as the current price of any particular stock on the Stock Exchange reflects all the hopes and fears relating to that stock, the rate of interest reflects all the current hopes and fears relating to the value of money. The most well known example of this is the phenomenon of inflation. Inflation is when the value of money is decreasing. If the value of money looks like going down, interest charges will go up because the cost of the borrowing will have to make allowances for the loss in value of a loan when it is repaid. This is why inflation usually produces high interest rates. The falling value of money has to be compensated for - otherwise it wouldn't be viable for a lender to provide loans.

Considering all the possibilities that can affect interest rates and the value of money, it might be expected that rates and values should vary chaotically. In fact they do, but, turbulence is kept in check by the individual actions of thousands of firms and individuals who are competing with each other to take advantage of any chaotic changes that occur. The net result of their competitive strategies is to create a relatively stable financial environment in which, all trade and commerce can reliably exist.

This stability is achieved through risk taking. The risk takers absorb the risks associated with change and uncertainty and make charges for doing so. These charges are transparent to everyday business and commerce because they are reflected in the various rates of interest charged.

It is through understanding how risk takers can make a profit by bringing stability to the financial markets that we will be able to work out how to profit in the unstable environment of the Internet.