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Interest Rate Spreads in a Theory of Financial Economics : A Proposed Model and Empirical Estimates

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  • Johnny Noe E. Ravalo

Abstract

This essay proposes a method of evaluating the size of the interest rate spread without alluding to any of the common structure-cartel propositions. Instead emphasis is on the component of portfolio risk that banks as financial intermediaries must bear. Intermediation is taken to be an asset from the point of view of banks. Its acquisition requires that banks maintain a unique portfolio that specifically short-sells deposit instruments so that it can take a position in the loan market that is beyond the limits of its pure equity exposure. The convenient decomposition derived in this essay is that the ensuing portfolio is exposed to the undiversifiable risk that is inherent of loan instrument (lending effect) and that which ?borrowing short to lend long? creates (intermediation effect). If such risks have any intrinsic value, it must follow that banks ought to be compensated by a rate of return that appropriately reflects such a market valuation. This leads directly into the issue of interest rate spreads since the estimate of the systematic portfolio risk can be used as a reference in determining the size of a risk-related spread. The model is empirically tested in the case of the Philippines using monthly data for the six-year period between January 1986 to December 1991. The empirical results suggest that the various measures of actual interest rate spread fall short of the implied ?fair? return for undiversifiable risk borne by banks.

Suggested Citation

  • Johnny Noe E. Ravalo, 1996. "Interest Rate Spreads in a Theory of Financial Economics : A Proposed Model and Empirical Estimates," UP School of Economics Discussion Papers 199603, University of the Philippines School of Economics.
    • Handle: RePEc:phs:dpaper:199603
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