What is Hedging In Finance? Learn the Basics with Examples
Trading guides, webinars and stories
Trading guides, webinars and stories
One of the favorite pastimes of Forex traders is to try and forecast the policies of national central banks. Chief among these policies is the expected interest rate. Most traders are acutely aware that these rates are critical to determining the relative price of a given currency. However, only a few pay attention to the fact that these banks don’t just set a single benchmark. Other than the base interest rate, they also define a number of different interest rates. Many of these form the basis of monetary policy.
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Central banks are the upper echelon of the banking system and they hold a unique position among financial institutes. While there can be any number of commercial banks in a given country, there’s always only one central bank. The two function virtually the same with one key exception. The central bank’s clients aren’t companies or individuals, but other banks. This means the central bank’s decisions will fundamentally define the business policies of other banks. That includes their lending and interest rates. This level of control allows them to influence their respective country’s money supply. By extension it also gives them power over inflation and other economic processes.
When we hear about a country’s interest rate it usually just refers to a simple benchmark. Meanwhile real interest rates can vary greatly. The base rate decisions are made by the monetary councils. They lead these banks and their d ecisions mainly affect the country’s treasury bill market. The benchmark is essentially nothing more than the risk-free rate of return. It also coincides with the yearly yields of treasury notes. This figure allows banks to compare their deposit interests. Even mutual funds use it to evaluate their returns on investment. As the name accurately implies, the base interest rate merely serves as a foundation for the financial sector. However, it does not affect specifics. For that there are a number of other sub-rates.
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One such sub-rate is the deposit interest rate. Commercial banks are obligated to hold a fraction of the funds deposited with them at the central bank. The latter determines the exact percentage of this reserve, which can range from 2-25%. The bank may receive interest on their deposit, although not always. Some central banks set the interest rates lower than the base rate. Sometimes even in the negative. At the time of writing the deposit interest rate is 0.1% in Canada. Meanwhile their base rate is 1.75%. In the Eurozone the former is -0.4% while the base rate is 0%.
In practice a negative deposit interest rate functions like a tax. Commercial banks are obligated to keep their funds at the central banks. These funds keep diminishing due to the negative rate. Banks try to offset their losses by reducing the minimum funds required to be deposited. They accomplish this by ramping up their lending activity. The less funds they have deposited the less they have to deposit themselves in turn. This is just one of the ways central banks can encourage lending activity to stimulate the economy.
If there’s a deposit interest rate, then there also has to be a lending rate. The latter refers to the interest banks pay the central bank when they borrow from it. In Europe this interest rate tends to be around 0.2% and generally higher than the deposit rate. This ensures that a lack of funds never gets in the way of a commercial bank’s lending activity. Many central banks keep the lending rate identical to the base interest rate. It was one of the strategies used to mitigate the 2008 subprime mortgage crisis for example. Banks considered “too big to fail” could borrow from The Fed at 0% interest to consolidate their liquidity.
The final type of interest rate is the interbank rate which is mainly significant for currency traders. It shows the interest rate used between banks and central banks during their end of day currency swaps. Some people also describe it as a short term overnight financing interest rate. It’s the one spot currency price traders deal with on a day to day basis. It’s also the basis for carry trades and the accounting of forward points. It’s the means by which central banks maintain the cost of speculating against their respective currency.
In 2018 the Turkish central bank reacted to the turbulent situation surrounding the lira, by raising the base interest rate to 24% and the interbank rate to 25.63%. This gave it a 23% rate advantage against the US dollar. Traders who expected the lira to weaken and sold it to buy dollars would have to face a loss of 23% per year. The high interest rates forced many people to close their lira shorts and instead take a long position. Doing so stabilized the declining price of the USDTRY pair.
The above example illustrates how critical this type of interest rate is to maintaining the stability of a currency. Raising the interbank or overnight rate won’t necessarily have a major impact like increasing the amount of money in circulation. Neither will it affect inflation or commercial banks’ ability to lend, but when push comes to shove it can stabilize a country’s currency.