Please read the article and answer these questions. Thanks. Article: TESTING THE
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Please read the article and answer these questions. Thanks.
Article:
TESTING THE GLOBAL CENTRAL BANK SWAP NETWORK
In the last few weeks, the ECB has been drawing on its liquidity swap line with the Fed, first $308 million for a week, then $658 million for a week, and last week back down to $358 million. What’s that about?
It’s not such a large amount. Bank of Japan borrowed more in the past, $810 million in March and $1528 million in January. But the question then repeats, what was that about?
Both of these drawings are part of the new set of central bank swap lines linking what I call the C6: the Fed, ECB, Bank of Japan, Bank of England, Swiss National Bank, and Bank of Canada. On October 31, 2013these lines were made permanent and unlimited; contract details may be found here. Ever since then I have had a slide in my powerpoints saying “Forget the G7, Watch the C6.”
So now we’re watching. What are we seeing?
Central bank swaps are in some ways quite similar to a standard commercial FX swap, but the differences are important and significant.
A standard swap involves exchange of two currencies today at the spot exchange rate prevailing today, plus a promise to reverse the transaction at maturity using the forward exchange rate prevailing today. Suppose that forward rate is calculated using covered interest parity as
F = S(1+r)/(1+r*)
where r and r* are respectively the dollar and foreign interest rate for a given term T, s is the spot exchange rate and f is the forward exchange rate for date T.
In this case, the exposure of the standard swap contract is identical to a swap of IOUs between the contracting parties at the prevailing interest rates in their respective currencies. One party borrows dollars at rate r and the other party borrows euros at the rate r*.
Central bank swaps are different. First, the forward rate in the contract is usually exactly the same as the current spot exchange rate. This means that central banks are never in the position of realizing profits or losses from the swap (although of course there will be implicit profits and losses), that come from deviation between the agreed forward rate and the spot rate at expiry.
Second, the interest rate on the contract is negotiated rather than calculated from market prices. But, given the choice of forward rate, the analogous commercial contract would call for payment of the interest differential, so anything different from that is significant. Significantly, the documentation of the current C6 swap line leaves open the question of who pays interest to who, and how much.
Usual practice has been for the party who draws on the line to pay interest on the line at some penalty rate. Thus the May 9, 2010 swap agreement between the Fed and ECB called for the ECB to pay the USD Overnight Index Swap Rate plus 100 basis points on its dollar borrowing, and the Fed to pay nothing on its euro borrowing. In effect, the ECB was simply borrowing dollars at the discount window, like any other bank, but with its own monetary liability serving as collateral instead of some financial asset.
This kind of arrangement is still in effect a swap of IOUs but at a price that is away from the market. Central bank swap lines thus in effect operate as a kind of outside spread providing bounds within which normal commercial dealing takes place. So long as prices stay at or near CIP, private agents prefer to do business directly with each other. But when CIP comes under pressure, because of one-sided liquidity flows, the central bank moves from backstop to market-maker and the outside price becomes the market price.
The ECB is borrowing dollars from the Fed and lending them on to banks in Europe who have dollar liquidity needs. Here is the tender documentation. Presumably it is doing this for banks who are unable, for whatever reason, to access dollar funding in the open market, or only at a premium that is higher than the ECB charges.
During the financial crisis, dollar funding needs like this got met by central bank liquidity swaps that rose almost to $600 billion, raising questions in Congress. Now, in normal times, smaller sums are becoming a routine way of handling the normal stresses and strains of world funding flows.
For lack of a world central bank, we have a network of central bank liquidity swaps.
(Council on Foreign Relations has a fun interactive app that shows the rest of the emerging swap network as well.)
Questions:
2. Forward rates in standard swaps are set relative to spot rates to eliminate arbitrage opportunities. Using a numerical example, demonstrate that an arbitrage opportunity would exist if a forward exchange rate quote differed from the formula given in Mehrling’s article.
3. How do swap lines between central banks differ from standard foreign exchange swap contracts? How are forward rates set? How are interest rates determined?
Explanation / Answer
Answer to Q-3)
Differences between swap lines and standard foreign exchange swap contracts
SWAP LINE- A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.
They allow a central bank to obtain foreign currency liquidity from the central bank that issues it – usually because they need to provide this to domestic commercial banks.
For example, the swap line with the Federal Reserve System enables the ECB and all the national central banks in the euro area (Euro system) to receive US dollars from the Fed in exchange for an equivalent amount of euro provided to the Federal Reserve. (also Supported by the Mehrling’s fact)
Swap Line Purpose- The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements. The liquidity is necessary to keep financial markets functioning smoothly during crises. It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up.
FOREIGN EXCHANGE SWAP- A foreign exchange swap is a contract under which two counterparties agree to exchange two currencies at a set rate and then to re-exchange those currencies at an agreed upon rate at a fixed date in the future.
Foreign exchange swaps have fixed settlement values and are not derivative instruments. That is, there is no payment uncertainty to manage—the terms of these transactions are fixed and agreed upon at the time of trade execution, and they do not change.
FX Swap Purpose- The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
Other Differences
Q- How Forward rates are set?
Ans- Forward rate appears in a contract where we have to exchange a currency after a pre-determined period in the future. The currency is always exchanged at the maturity date of the contract in the future and not immediately when the contract is signed up. So, to determine or set the forward rate we have to know two things-
(a) the interest rates between the money markets of the two countries; and
(b) the interest arbitrages.
In the absence of anticipated movements of foreign exchange rate, the forward rate will be the same as the spot rate if rates of interest are the same in the two money markets.
On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.
Q- How Interest Rates are Determined?
Ans- In countries using a centralized banking model, interest rates are determined by their respective central banks.
In order to determine the interest rate, a government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).
In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Following are the three factors which help to determine the interest rate-
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank. Depending on the kind of account you open the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the repayment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.
Answer to Q-3)
Differences between swap lines and standard foreign exchange swap contracts
SWAP LINE- A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.
They allow a central bank to obtain foreign currency liquidity from the central bank that issues it – usually because they need to provide this to domestic commercial banks.
For example, the swap line with the Federal Reserve System enables the ECB and all the national central banks in the euro area (Euro system) to receive US dollars from the Fed in exchange for an equivalent amount of euro provided to the Federal Reserve. (also Supported by the Mehrling’s fact)
Swap Line Purpose- The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements. The liquidity is necessary to keep financial markets functioning smoothly during crises. It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up.
FOREIGN EXCHANGE SWAP- A foreign exchange swap is a contract under which two counterparties agree to exchange two currencies at a set rate and then to re-exchange those currencies at an agreed upon rate at a fixed date in the future.
Foreign exchange swaps have fixed settlement values and are not derivative instruments. That is, there is no payment uncertainty to manage—the terms of these transactions are fixed and agreed upon at the time of trade execution, and they do not change.
FX Swap Purpose- The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
Other Differences
Q- How Forward rates are set?
Ans- Forward rate appears in a contract where we have to exchange a currency after a pre-determined period in the future. The currency is always exchanged at the maturity date of the contract in the future and not immediately when the contract is signed up. So, to determine or set the forward rate we have to know two things-
(a) the interest rates between the money markets of the two countries; and
(b) the interest arbitrages.
In the absence of anticipated movements of foreign exchange rate, the forward rate will be the same as the spot rate if rates of interest are the same in the two money markets.
On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.
Q- How Interest Rates are Determined?
Ans- In countries using a centralized banking model, interest rates are determined by their respective central banks.
In order to determine the interest rate, a government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).
In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Following are the three factors which help to determine the interest rate-
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank. Depending on the kind of account you open the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the repayment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.
Answer to Q-3)
Differences between swap lines and standard foreign exchange swap contracts
SWAP LINE- A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.
They allow a central bank to obtain foreign currency liquidity from the central bank that issues it – usually because they need to provide this to domestic commercial banks.
For example, the swap line with the Federal Reserve System enables the ECB and all the national central banks in the euro area (Euro system) to receive US dollars from the Fed in exchange for an equivalent amount of euro provided to the Federal Reserve. (also Supported by the Mehrling’s fact)
Swap Line Purpose- The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements. The liquidity is necessary to keep financial markets functioning smoothly during crises. It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up.
FOREIGN EXCHANGE SWAP- A foreign exchange swap is a contract under which two counterparties agree to exchange two currencies at a set rate and then to re-exchange those currencies at an agreed upon rate at a fixed date in the future.
Foreign exchange swaps have fixed settlement values and are not derivative instruments. That is, there is no payment uncertainty to manage—the terms of these transactions are fixed and agreed upon at the time of trade execution, and they do not change.
FX Swap Purpose- The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
Other Differences
Foreign exchange swaps involve the exchange of more than one currency. Unlike other instruments covered under the CEA, these instruments are not simply denominated in U.S. dollars or another single currency. This facility is restricted to swap lines between central banks.
Foreign exchange swaps require the ability to physically settle the transfer of multiple currencies for each transaction, unlike the swap lines between central banks where only their own currency is traded.
Q- How Forward rates are set?
Ans- Forward rate appears in a contract where we have to exchange a currency after a pre-determined period in the future. The currency is always exchanged at the maturity date of the contract in the future and not immediately when the contract is signed up. So, to determine or set the forward rate we have to know two things-
(a) the interest rates between the money markets of the two countries; and
(b) the interest arbitrages.
In the absence of anticipated movements of foreign exchange rate, the forward rate will be the same as the spot rate if rates of interest are the same in the two money markets.
On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.
Q- How Interest Rates are Determined?
Ans- In countries using a centralized banking model, interest rates are determined by their respective central banks.
In order to determine the interest rate, a government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).
In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Following are the three factors which help to determine the interest rate-
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank. Depending on the kind of account you open the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the repayment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.
Inflation
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
Government
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.
Answer to Q-3)
Differences between swap lines and standard foreign exchange swap contracts
SWAP LINE- A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.
They allow a central bank to obtain foreign currency liquidity from the central bank that issues it – usually because they need to provide this to domestic commercial banks.
For example, the swap line with the Federal Reserve System enables the ECB and all the national central banks in the euro area (Euro system) to receive US dollars from the Fed in exchange for an equivalent amount of euro provided to the Federal Reserve. (also Supported by the Mehrling’s fact)
Swap Line Purpose- The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements. The liquidity is necessary to keep financial markets functioning smoothly during crises. It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up.
FOREIGN EXCHANGE SWAP- A foreign exchange swap is a contract under which two counterparties agree to exchange two currencies at a set rate and then to re-exchange those currencies at an agreed upon rate at a fixed date in the future.
Foreign exchange swaps have fixed settlement values and are not derivative instruments. That is, there is no payment uncertainty to manage—the terms of these transactions are fixed and agreed upon at the time of trade execution, and they do not change.
FX Swap Purpose- The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
Other Differences
Foreign exchange swaps involve the exchange of more than one currency. Unlike other instruments covered under the CEA, these instruments are not simply denominated in U.S. dollars or another single currency. This facility is restricted to swap lines between central banks.
Foreign exchange swaps require the ability to physically settle the transfer of multiple currencies for each transaction, unlike the swap lines between central banks where only their own currency is traded.
Q- How Forward rates are set?
Ans- Forward rate appears in a contract where we have to exchange a currency after a pre-determined period in the future. The currency is always exchanged at the maturity date of the contract in the future and not immediately when the contract is signed up. So, to determine or set the forward rate we have to know two things-
(a) the interest rates between the money markets of the two countries; and
(b) the interest arbitrages.
In the absence of anticipated movements of foreign exchange rate, the forward rate will be the same as the spot rate if rates of interest are the same in the two money markets.
On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.
Q- How Interest Rates are Determined?
Ans- In countries using a centralized banking model, interest rates are determined by their respective central banks.
In order to determine the interest rate, a government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).
In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Following are the three factors which help to determine the interest rate-
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank. Depending on the kind of account you open the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the repayment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.
Inflation
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
Government
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.
Answer to Q-3)
Differences between swap lines and standard foreign exchange swap contracts
SWAP LINE- A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.
They allow a central bank to obtain foreign currency liquidity from the central bank that issues it – usually because they need to provide this to domestic commercial banks.
For example, the swap line with the Federal Reserve System enables the ECB and all the national central banks in the euro area (Euro system) to receive US dollars from the Fed in exchange for an equivalent amount of euro provided to the Federal Reserve. (also Supported by the Mehrling’s fact)
Swap Line Purpose- The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their private banks to maintain their reserve requirements. The liquidity is necessary to keep financial markets functioning smoothly during crises. It reassures banks and investors that it's safe to trade in that currency. It also confirms that the central banks won't let the supply of that currency dry up.
FOREIGN EXCHANGE SWAP- A foreign exchange swap is a contract under which two counterparties agree to exchange two currencies at a set rate and then to re-exchange those currencies at an agreed upon rate at a fixed date in the future.
Foreign exchange swaps have fixed settlement values and are not derivative instruments. That is, there is no payment uncertainty to manage—the terms of these transactions are fixed and agreed upon at the time of trade execution, and they do not change.
FX Swap Purpose- The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
Other Differences
Foreign exchange swaps involve the exchange of more than one currency. Unlike other instruments covered under the CEA, these instruments are not simply denominated in U.S. dollars or another single currency. This facility is restricted to swap lines between central banks.
Foreign exchange swaps require the ability to physically settle the transfer of multiple currencies for each transaction, unlike the swap lines between central banks where only their own currency is traded.
Q- How Forward rates are set?
Ans- Forward rate appears in a contract where we have to exchange a currency after a pre-determined period in the future. The currency is always exchanged at the maturity date of the contract in the future and not immediately when the contract is signed up. So, to determine or set the forward rate we have to know two things-
(a) the interest rates between the money markets of the two countries; and
(b) the interest arbitrages.
In the absence of anticipated movements of foreign exchange rate, the forward rate will be the same as the spot rate if rates of interest are the same in the two money markets.
On the other hand, if the interest rates are different in the two money markets, the difference will be reflected by the difference between the forward and the spot rates.
Q- How Interest Rates are Determined?
Ans- In countries using a centralized banking model, interest rates are determined by their respective central banks.
In order to determine the interest rate, a government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease).
In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
Following are the three factors which help to determine the interest rate-
Supply and demand
Interest rate levels are a factor of the supply and demand of credit. An increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. Credit available to the economy is decreased as lenders decide to defer the repayment of their loans.
Inflation
The higher the inflation rate, the more interest rates are likely to rise. This occurs because the lenders will demand higher interest rate as compensation for the decrease in purchasing power of the money they will be repaid in the future.
Government
The state of the economy determines how markets and the Fed set rates. While the Fed sets the overnight interest rate directly (and could theoretically control all nominal US rates) we should not confuse this as being the same as the Fed controlling all interest rates. Instead, the Fed sets a portion of the interest rate market in an attempt to influence the broader economy. But the Fed does not control the economy or all interest rates in the economy. It’s the state of the economy that determines the interest rate.
In India, With the launch of Financial sector reforms, banks got the freedom to set their interest rates subjected to RBI Guidelines. Interest rate of a bank is basically determined by that bank itself. The Bank’s asset and liability management committee meets to set the interest rate charged from its customers.
- Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank. Depending on the kind of account you open the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the repayment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.
- Inflation
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they will be repaid in the future.
- Government
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend. That rate then eventually trickles down into other short-term lending rates. The Fed influences these rates with "open market transactions," which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates decrease. When the government sells securities, money from the banks is drained for the transaction, rendering fewer funds at the banks' disposal for lending, forcing a rise in interest rates.
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