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CHAPTER 10 INTEREST RATES

INTEREST RATE HISTORY AND MONEY MARKET RATES

Prime rate: the basic interest rate on short-term loans that the largest commercial banks charge to their most

creditworthy corporate customers

o Rates are quoted as prime plus or minus a spread

Bellwether rate: interest rate that serves as a leader or as a leading indicator of future trends; interest rates as a

bellwether of inflation

Bank rate: interest rate that the Bank of Canada offers to commercial banks for overnight-reserve loans

o Discount rate is the interest rate that the bank offers to commercial banks for overnight reserve loans

Increasing discount rate means bank may be signalling that it intends to pursue a tight-money

policy, most likely to control budding inflationary pressures

Decreasing discount rate means bank may be signalling an intent to pursue a loose-money policy

to stimulate economic activity

Call money rate: interest rate brokerage firms pay for call money loans, which are bank loans to brokerage firms

o This rate is used as a basis for customer rates on margin loans

Commercial paper: short-term, unsecured debt issued by the largest corporations

Certificates of deposit (CDs): large-denomination deposits of $100,000 or more at commercial banks for a specific

term

o Interest rate paid on CDs varies according to the term of the deposit; the longer the term, the lower the

interest rate

Bankers acceptance: a postdated cheque on which a bank has guaranteed payment; commonly used to finance

international trade transactions

o They are short-term, marketable securities and they are guaranteed by both the borrower and the bank

Eurodollars: certificates of deposit denominated in US dollars at commercial banks outside the USA

London interbank offered rate (LIBOR): interest rate that international banks charge one another for overnight

Eurodollar loans

Treasury bills (T-bills): a short-term government debt instrument

MONEY MARKET PRICES AND RATES

Pure discount security: an interest-bearing asset that makes a single payment of face value at maturity with no

payments before maturity

o Yield on an interest-bearing asset is simply a measure of the interest rate being offered by the asset

Basis point: with regard to interest rates or bond yields, one basis point is 1 percent of 1 percent (0.01%)

Bank discount basis: a method for quoting interest rates on money market instruments

CURRENT PRICE = FACE VALUE x (1 – [DAYS TO MATURITY/360] x DISCOUNT YIELD)

EX. Suppose a banker’s acceptance has a face value of $1 million that will be paid in 90 days. If the interest rate, quoted on a discount basis, is

5%, what is the current price of the acceptance?

$1,000,000 x [1 – (90/360) x 0.5] = $987,500

The “discount” is the difference between the face value and the price $1,000,000 - $987,500 = $12,500

Bond equivalent yield: a method for quoting Canadian treasury bills

BOND EQUIVALENT YIELD = [($1000 – PRICE)/PRICE] x [365/DAYS TILL MATURITY]

EX. Consider the bill issue with 155 days to maturity, with a bid discount of 3.52% and an asked discount rate of 3.51%. For a $1 million face

value T-bill, the corresponding bid and asked prices can be calculated using the discounts shown along with our bank discount basis pricing

formula.

$1,000,000 x [1 – (155/360) x 0.0352] = $984,844.44

Bank discount yield is converted to a bond equivalent yield using the following formula

o This conversion formula is correct for maturities of six months or less

o Must use 366 days if February 29 (leap year) occurs within the next 12 months

BOND EQUILALENT YIELD = (365 x DISCOUNT YIELD) / (360 – DAYS TO MATURITY x DISCOUNT YIELD)

EX. Suppose the asked discount rate on a T-bill with 170 days to maturity is 3.22%. What is the bond equivalent yield?

(365 x 0.0322) / (360 – 170 x 0.0322) = 3.315%

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