2.2.1 Interest rates: treasury note, LIBOR, credit spread

To compensate for the risk of not getting the back the money, investors in the credit market ask for higher interest rate when the credit worthiness of a borrower deteriorates.

Always at the bottom, the central bank has virtually no risk of defaulting because it can always print money if it needs to: it pays the so-called treasury rate (TR) to commercial banks, in return for the margin deposit the latter have to make in order to obtain a banking liscence. The chairman of the Federal Reserve Bank (Fed), the European Central Bank (ECB) and indeed every central bank are responsible for setting the interest rate to steer the economy. For example, by raising the treasury rate, the central bank makes the money more valuable for commercial banks, who in turn, pay a higher interest rate to attract more money from their customers. This is how the central bank tightened its monetary policy and reduced the flow of capital to fight inflation in the early 1990's. On the contrary, (2.2.1#fig.1) suggest that historically low rate have been used during 2002-2004 to stimulate economic growth.

Figure 2.2.1#fig.1: Treasury rate set by the US Federal Reserve bank

For relatively short times (overnight up to 12 months), high-credit financial institutions can borrow money in the inter-bank interest rate market (such as the London Inter-Bank Offered Rate or LIBOR), at a rate that is only marginally higher than the treasury rate.

Not to be mixed up with the central bank, the government often borrows money for a longer time to finance big construction projects. Rather than the credit worthiness, it is the expected long-term average rate that generally decides on the spot rate investors are willing to pay. Have a look at the MKTSolution applet below to verify how the yield from the 10 years US Treasury bill clealy follows the trend set by the central bank, with a minium yield of 3.1% in June 2003 when the Treasury rate reached the minimum of 1%. The credit spread of 2100 bps (basis points or hundredth of one percent, here 2.1%) does however change on a daily basis and discounts the investors expectation of future movements from the Fed.

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