FM for Actuaries

296 CHAPTER 9
9.2 Financial Securities
Having delineated the determination of the yield of a financial asset, we now consider
the yields of different types of securities traded in the financial markets. Yield
(or interest rate) data can be obtained from various sources. They can be found in
the websites of the Central Banks, such as the Board of Governors of the Federal
Reserve System (the Fed), Bank of England, Bank of Canada and European Central
Bank. Major financial media such as the Wall Street Journal, The Financial
Times, Thomson Reuters and Bloomberg publish extensive data on interest rates.
In addition, specific data can be found in the websites of exchanges and trade organizations
such as the Intercontinental Exchange (ICE) and the International Swaps
and Derivatives Association (ISDA).
Table 9.1 presents a sample of yields of different financial assets. They are
taken from the Fed’s website, covering some securities from the U.S. market, and
the ICE, covering some securities from the London market. It can be seen that the
yields of these securities may be quite different, which is the result of the interaction
of the different risk premium components discussed in the last section. In what
follows, we take a closer look at each of the selected securities.
The first two instruments in the U.S. market, the Federal funds and Discount
Window credit, are the main policy instruments through which the Fed manages its
monetary policy. Federal funds are the reserve balances that private banks keep at
their local Federal Reserve Bank. Private banks lend Federal funds to each other
to meet temporary shortages in liquidity. While the Fed cannot dictate the interest
rate banks charge each other for such borrowing, it regularly announces its target
rate to let market participants know about its policy direction. In December 2015,
the Fed raised the target range of the Federal funds interest rate to 0.25% to 0.5%,
indicating its intention to tighten the credit market.
The Fed tries to keep the Federal funds rate within the target range by trading
short-term securities. When the Fed wants to increase reserves (and lower the Federal
funds rate), it buys Treasury securities. On the other hand, when the Fed wants
to reduce reserves (and raise the Federal funds rate) it sells Treasury securities. The
short-term transactions the Fed uses for this purpose are called repurchase agreements
or repos. 1 The Federal funds (effective) rate reported in Table 9.1 is the
daily rate computed as a weighted average of rates quoted on brokered trades. It
can be seen that its value of 0.38% is within the targeted range announced by the
Fed.
The Discount Window is an instrument that allows eligible institutions and
banks to borrow money directly from the Fed on a short-term basis to meet temporary
shortage of liquidity. Unlike the Federal funds rate, the Fed has direct control
1 See the forthcoming discussions on repurchase agreements.