Chapter 4 - Interest Rates

Question 1

What is the relationship between the risk-free rate and the pricing of derivatives?

Answer 1

Derivatives are prices so that they return the risk-free rate or minimize exposure to rf.

Question 2

What is LIBOR?

Answer 2

London Interbank Offered Rate: LIBOR is the rate of interest at which a AA bank can borrow money on an unsecured basis from another bank.
For 5 currencies and 7 maturities ranging it is
calculated daily from the submissions from
a number of major banks (EUR, USD, CHF, GBP, JPY).

Question 3

What is the U.S. Fed Funds Rate?

Answer 3

Unsecured interbank overnight rate of interest, Allows banks to adjust the cash (i.e., reserves) on
deposit with the Federal Reserve at the end of each
day. It’s the rate for banks lending (surplus) to banks overnight (shortage). It is unsecured.

Question 4

What is a repurchase agreement?

Answer 4

Repurchase agreement is an agreement where a financial institution that owns securities agrees to sell them for X and buy them bank in the future (usually the next day) for a slightly higher price, Y.

The rate of interest is calculated from the difference between X and Y and is known as the repo rate