§2. Relations Between the Various Rates

No very satisfactory theoretical treatment of the general relations between interest and risk has yet been worked out. But for practical purposes, a good usage is to limit the term "interest" to fairly safe loans and staple or standard market quotations and to designate by some other term, such as dividends or profits, the other less certain and less standardized rates. Another usage is to reckon as net profits or net losses the difference between Edition: current; Page: [209] these less standardized rates and a normal rate of interest so far as this can be expressed in figures. Thus a man who has invested $100,000 in common stock and is getting an income of $15,000 may think of $5,000 of this, or 5 per cent, as a fair interest on his investment and the remaining $10,000, or 10 per cent, as net profit. But we do not need here to enter into such discussions, especially in so far as they are only verbal. All that is here needed is to show briefly how risk modifies the theoretically perfect determination of the interest rate thus far made.

The rate in every loan contract is adjusted according to the degree of security given. Thus, security or guarantee may be furnished by a simple endorsement of reputable persons, in which case the degree of security will be the greater the larger the number of endorsers and the higher the credit which they possess, or it may be by the deposit of collateral securities. Thus the very name security has come to mean the properties themselves rather than their safety.

If we pass from explicit interest, or the rate of interest involved in a loan contract, to implicit interest, or the rate involved in purchases and sales of property in general, we see again that the greater the risk, the higher the basis on which a security will sell. A gilt-edge security may sell on a 3 per cent basis, when a less known or less salable security may sell only on a 6, or even on a 9 per cent basis.76

The period of time a loan or bond runs is also an important factor as regards risk.77 There is a see-saw between Edition: current; Page: [210] the rates on short term and long term loans. That is, if the short term rate is greatly above the long term, it is likely to fall, or if greatly below, to rise. The long term rates thus set a rough norm for the short term rates, which are much more variable. When the future is regarded as safer than usual, loan contracts tend to be longer in time than otherwise. In a stable country like the United States, railway and government securities are thus often drawn for half a century or more. There is also a variability according to the degree of liquidity. A call loan which may be recalled on a few hours' notice has a very different relation to risk than does a mortgage, for instance. The call rate is usually lower than time rates because money on call is a little like money on deposit, or ready money. It is ready, or nearly ready, for use whenever occasion demands. This readiness or convenience takes the place of some of the interest. On the other hand, a sudden shortage of funds in the call loan market may send the call rates far above time rates and keep them there until the slow working forces release "time-money" and transfer it to the call loan market. Thus the call loan rates are very volatile and mobile in both directions.

The element of risk will affect also the value and basis of the collateral securities. Their availability for collateral will increase their salability and enhance their price. On the other hand, when, as in times of crisis, the collateral has to be sold, it often happens that for purposes of liquidation it is sold at a sacrifice.