Type of Rates

Type of Rates

 

For any given currency many different types of interest rates are regularly quoted. These include mortgage rate, deposit rate, prime rates, and so on. The interest rate applicable in a situation depends on the credit risk. The higher the credit risk, the higher the interest rate. We introduce that are particularly important in options and futures markets.

 

1. Treasury Rates

Treasury rates are the interest rates applicable to borrowing by a government in its own currency. For example, U.S. Treasury rates are the rates at which the U.S. government can borrow in U.S. dollars; Japanese Treasury rates are the rates at which Japanese government can borrow in yen; and so on. It is usually assumed that there is no chance that a government will default on an obligation denominated in its own currency. The reason for this is that government can always meet it obligation by printing more money. For this reason, Treasury rates are often termed risk-free rates.

 

2. LIBOR Rates

 

Large international banks actively trade with each other 1-month, 2-month, 6-month, and 12-month deposits denominated in all of the world’s major currencies. At a particular time Citibank might quote a bid rate of 6.250% and an offer rate of 6.375% to other banks for six-month deposits in Australian dollars. This means that it is prepared to pay 6.250% per annum on six-month deposits from another bank or advance deposits to another bank at the rate of 6.375% per annum. The bid rate is known as the London Interbank Bid Rate, or LIBID. The offer rate is known as the London Interbank Offer Rate, or LIBOR. The rates are determined in trading between banks and change as economic conditions change. If more banks want to borrow funds than lend funds, LIBID and LIBOR increase. If the reverse is true, they decrease.

 

LIBOR is a widely used reference rate. LIBOR rates are generally higher than the corresponding Treasury rates because they are not risk-free rates. There is always some chance (albeit small) that the bank borrowing the money will default. Banks and other large financial institutions tend to use the LIBOR rate rather than the Treasury rate as the “risk-free rate” when they evaluate derivatives transactions. The reason is that financial institutions invest surplus funds in the LIBOR market and borrow to meet their short-term funding requirement in this market. They regard LIBOR as their opportunity cost of capital.

 

3. Repo Rates

 

Sometimes an investment dealer funds its trading activities with a repo or repurchase agreement. This is a contract where an investment dealer who owns securities agrees to sell them to another company now and buy them back later at a slightly higher price. The company is providing a loan to the investment dealer. The difference between the price at which the securities are sold and the price at which they are repurchased is the interest it earns. The interest rate is referred to as the repo rate. If structured carefully, the loan involves very little credit risk. If the original owner of the securities does not honor the agreement, the lending company simply keeps the securities. If the lending company does not keep to its side of the agreement, the original owner of securities keeps the cash.

The most common type of repo is an overnight repo, in which the agreement is renegotiated each day. However, longer-term arrangements, known as term repo, are sometimes used.