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York University (12,828)
ADMS 3531 (17)
Chapter 10

Chapter 10 Detailed Note.docx

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Department
Administrative Studies
Course
ADMS 3531
Professor
Dale Domian
Semester
Winter

Description
Chapter 10: Interest Rates 10.1 Interest Rate History and Money Market Rates Time Value of Money n FUTURE VALUE = PRESENT VALUE x (1+r) PRESENT VALUE = FUTURE VALUE / (1+r) n 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 - prime rate is a key short-term interest rate since it is the basic for interest rates that large commercial banks charge on short-term loans (rates are quoted as prime plus or minus a spread) - the prime rate is well known as a bellwether rate, which is the interest rate that serves as a leader or as a leading indicator of future trends, e.g., interest rates as a bellwether of inflation - discount rate: the interest rate that the bank offers to commercial banks for overnight reserve loans - when a bank cannot supply sufficient reserves from internal sources, it must borrow reserves from other banks through the Bank of Canada - Bank of Canada is the central bank of Canada, it is charged with the responsibility of managing interest rates and the money supply to control inflation and promote stable economic growth - bank rate: the interest rate that the Bank of Canada offers to commercial banks for overnight reserve loans - by increasing the discount rate, the bank may be signalling that is intends to pursue a tight-money policy, most likely to control budding inflationary pressures - by decreasing the discount rate, the bank may be signalling an intent to pursue a loose-money policy to stimulate economic activity - Federal funds rate: interest rate that banks charge each other for overnight loans of $1 million or more - banker’s acceptance: a postdated check on which a bank has guaranteed payment (commonly used to finance international trade transactions) - call money rate: the interest rate brokerage firms pay for call money loans from banks. This rate is used as the basis for customer rates on margin loans - the call money rate is the basic rate that brokers use to set interest rates on customer call money loans - brokers typically charge their customers the call money rate plus a premium, where the broker and the customer may negotiate the premium - commercial paper: short-term, unsecured debt issued by the largest corporations - the commercial paper market is dominated by financial corporations, such as banks and insurance companies, or financial subsidiaries of large corporations - certificates of deposit or CDs: the interest rate on certificates of deposit, which are large-denomination deposits of $100,000 or more at commercial banks - the interest rate paid on CDs usually varies according to the term of the deposit (i.e., a one year CD may pay a higher interest rate than a six month CD) - banker’s acceptance: a postdated cheque upon which a commercial bank has guaranteed payment - banker’s acceptance are normally used to finance international trade transactions (for example, as an importer, you wish to purchase computer components from a company in Singapore and pay for the goods three months after delivery, so you write a postdated cheque. You and the exporter agree, however, that once the goods are shipped, your bank will guarantee payment on the date specified on the cheque. After your goods are shipped, the exporter presents the relevant documentation, and, if all is in order, your bank stamps the word ACCEPTED on your cheque) - Eurodollars: certificates of deposit denominated in US dollars at commercial banks outside the USA - they are interest rates paid for large-denomination deposits - London Interbank Offered Rate (LIBOR): the interest rate offered by London commercial banks for dollar deposits from other banks - the LIBOR is the most frequently cited rate used to represent the London money market - bank lending rates are often stated as LIBOR plus a premium, where the premium is negotiated by the bank and its customer - Treasury bills (T-bills): a short-term federal government debt instrument - Treasury bill interest rates set during the most recent bi-weekly Treasury bill auction - interest rates determined at each Treasury bill auction are closely watched by professional money managers throughout the world 10.2 Money Market Prices and Rates - pure discount security: is an interest-bearing asset that makes a single payment of face value at maturity with no payments before maturity - there are several different ways market participants quote interest rates: • Bank Discount Basis o The Bank Discount Basis is a method of quoting interest rates on money market instruments o It is commonly used for T-bills and banker’s acceptances o The formula is: Current Price = Face Value x [1 – (Days to Maturity / 360) x Discount Yield] o Note that we use 360 days in a year in this (and many other) money market formula o The term “discount yield” here simply refers to the quoted interest rate • Treasury Bill Quotes o The formula is: Current T-Bill Price = Face Value x [1 – (Days to Maturity / 360) x Discount Yield] • Bond Equivalent Yields (BEY) o Canadian T-bills rates are quoted using bond equivalent yield instead of bank discount yield o Bond equivalent yield uses 365 day
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