Topic 7: Money Markets, Monetary Policy and Interest Rates Flashcards
How do central banks conduct monetary policy
move overnight interest rate by intervening in reserves market
can move long-term rates by intervening in bond market (QE)
How are settlements done through a central bank
through transfer of reserves which both parties (the two banks transferring to each other) have stored in the central bank
what happens if a bank has negative reserves at 4:30 EST
goes to interbank loan market and will get an uncollateralized loan from another bank with interest
what is the interbank rate
rate negotiated bilaterally
average across all banks is the interbank rate, called fed funds rate in the US
how to repo loans work
bank anticipates it will have negative reserves at end of day
will agree a repo loan from another bank
will repay tomorrow or at later date with interest
loan is collateralized typically with gov bond or MBS
typically used for non-urgent reserves management
why are repo loans called repo
repo = repurchase agreement
essentially sells the loans (the collateral) to the lending bank and agrees to buy it back at a fixed price when the loan matures
what determines repo rate
rate negotiated bilaterally (market determined rate)
can be deduced by sale and repo price (e.g. if sale price is 100 and repo price is 100.5 then repo rate is 0.5/100 = 0.5%)
for most types of collateral, repo rate - general collateral rate (GCR)
for collateral high in demand, repo rate is less that GCR
who are participants in repo market
does not involve only banks
can also borrow from other FIs e.g. bank can borrow from money market fund
other FIs can also borrow from banks in repo market e.g. hedgefund can borrow from bank
some FIs enter in repo contracts to get hold of the collateral e.g. hedge fund wanting to short a government bond so gets the collateral by lending money to bank, then shorts it
what happens if bank has negative reserves at 6:30
only option is discount window
overnight loan of reserves from central bank
rate is set by central bank, penalty rate 0.25-1% above interbank rate
loan typically made against collateral
lender of last resort for banks
what is the relationship between all these rates
interbank rate, repo rate and t-bill rate are related
focus on interbank rate = base rate for all money markets
interbank market (=reserves market) is the basis for all money markets
what are the four tools central banks have to move interbank rate
open market operations
interest paid on reserves
discount window loans
depository reserve requirements
how does open market operations affect interbank rate in equilibrium
bank gives t bill to central bank
central bank adds this onto the banks reserves
increase supply of reserves
shift supply curve right
interbank rate falls
overall:
raising TR - expansionary (inject liquidity)
reducing TR - contractionary (remove liquidity)
how to central banks typically conduct open market operations
through a dealer (investment bank e.g. morgan stanley)
typically done with repo
what is policy tool 2 (interest paid on reserves)
reserve interest rate is a floor for the interbank rate (bank will not lend below the rate they get from central bank)
floor is achieved when reserves are large
reserves have become large in recent decade due to QE
interest on reserves has become the main policy for changing interbank rate for many central banks
how does supply of reserves affect interest paid on reserves mechanism
if reserves are relatively low, banks wont really care about reserve rate because they can just lend in interbank market at a higher rate (use graph for visualisation) but interbank rate will decrease if total reserves increase
if reserves are large, central banks can easily control interbank rate because the interbank rate will be at the floor (reserve rate) so they have control since reserve rate = interbank rate (again use graph for visualisation)
how does demand for reserves increasing impact central banks ability to control interbank rate when reserves are large
same again, greater control, increase in R(i) will not move i* when reserves are large since at floor
how does increase in reserve rate affect interbank rate when reserves are large
increases i* accordingly with reserve rate increase
how to discount window rates affect interbank rate
discount window rate is a ceiling for interbank rate, increase in demand for reserves will not increase i* above discount window rate
discount window loan raises total reserves
what is the depository reserve requirement tool of central banks
bank reserves + vault cash must be greater than a certain fraction of deposits (10% in US)
depositary reserve requirements are in addition to reserves and is also an additional requirement on top of reserves being greater than 0 (if DRR exists)
demand for reserves = required reserves + excess reserves (nowadays mainle excess)
why do banks prefer keeping reserves vs cash
no storage costs since electronic
earn interest on reserves
banks could technically exchange on a one to one basis cash and reserves
what did reserves consist of in 2019 and why
excess reserves very large due to QE
borrowed reserves very small
vault cash small
what did reserves consist of in 2020 and why
excess reserves grew substantially due to more QE
borrowed reserves also increased since some banks had to borrow from central bank
depository reserve requirements cut to 0
vault cash went to 0
what did reserves consist of in 2021
excess reserves grew further
borrowed reserves remained high
vault cash still 0
what did reserves consist of in 2022 summer
excess reserves been shrinking
borrowed reserves came down
vault cash still 0
what are the three theories which explain yield curve shape (term structure shape)
expectations theory
liquidity preference theory
preferred habitat theory
what does expectations theory state
investing in long maturity bonds returns the same on average and over a given investment horizon as short maturity bonds
if upward sloping - market is expecting rates to increase in the future and vice versa if downward sloping
what is the liquidity preference theory
investors prefer short maturity bonds because they want guaranteed returns over a short maturity
therefore short maturity bonds have lower expected returns than long maturity bonds over any given time horizon
therefore yield curve slopes upwards
what is the preferred habitat theory
rates are determined by local supply/demand
generalizes liquidity preference theory, which assumes investors prefer short maturity, PHT says investors can sometimes prefer long maturity bonds e.g. pension funds
UK pension fund reform
pension funds had to meet a minimum ratio of assets to liabilities
need a discount rate to value their liabilities
pensions act of ‘04 - discount rates for pension fund liabilities = yield on long term inflation indexed government bonds
what were the unintended consequences of the uk pension fund reform
large hedging demand for these bonds since:
if yield on LT inflation indexed gilts drops, liabilities will shoot up (since discounted by this)
hedged by buying the 15 year inflation indexed gilt so if the yield drops (i.e. price of bond increases) the assets increase as much as the liabilities
as a result, term structure (yield curve) inverted as long term financing became cheaper than short term financing
what does steep upward sloping yield curve imply according to expectations theory
short rates should rise
e.g. if r1 is 4% and r2 is 5% then the 1 year one should be ~6% in a year so you have same return over same horizon
how does exp theory actually work in real life
slope of term structure does predict yield of short term bonds in the future but in reality they don’t rise to the same level as implied by expectations theory and hence long term bonds outperform short term bonds when upwards sloping yield curve (positive excess returns)
what happens to currency when central bank lowers overnight rate
home currency depreciates since can get higher return from other currencies
what is uncovered interest parity
Holding any currency returns the same, on average and over a given
investment horizon
what are the implications of uncovered interest parity
Home interest rate > Foreign interest rate → Home currency expected to
depreciate.
Home interest rate < Foreign interest rate → Home currency expected to
appreciate.
Decline in home interest rate → Home currency depreciates to a point from
which it is expected to appreciate.
Currency overshooting.
