Let’s talk more about the current sub-prime mess and learn some more concepts about the monetary policy used in the CFA exams.

Due to the sub-prime mess, banks won’t lend their money easily due credit issues and, most importantly, to ensure themselves having enough liquidity in case of emergencies. As a result the interest rate surges. This rate is called the Federal Funds Rate.

Federal Funds Rate is the rate banks charge each other for inter-bank lending. This rate is what you usually heard from the news that the Fed has set the target at a particular level (e.g. the current the target is 5.25%). But remember, the Fed’s Federal Open Market Committee (FOMC) only set the target. In order to achieve the goal, they have to sell/ buy government securities through open market operations.

Last Friday (August 11, 2007), despite the current target being 5.25%, the federal funds rate once ticked above 6%! It means that the liquidity has dropped substantially. In order to solve this issue, and regain the target of 5.25%, Fed announced a three-day repurchase agreement (repo) and injected totally $38 billion into the market!

Open Market Operation is a part of the Monetary Policy for the Fed to control interest rate and, thus, the inflation rate. This is the most commonly use policy (others are Bank Discount Rate and Bank Reserve Requirement). In an Open Market, the Fed injects money by selling or buying government securities to decrease or increase the monetary supply in the market respectively.

In this case, they announced a 3-day repo. In a repo, the dealers sell the government securities and agree to repurchase at a higher price at a particular time. And this implies an annualized rate, repo rate. If it is for 1 day, it is called overnight repo. For longer terms, it is called term repo. In this case, the Fed buys securities from the dealers and offers them money which they will deposit in the commercial banks (so the banking system suddenly has $38 billion more money).

Because of the Fed’s intervention, the Federal Funds Rate once dropped to 5% by the end of the day which is below the target set by Fed! And this eased the market a lot and the Dow Jones Industrial Average (DJIA) dropped by only 31.14 points on Friday.

Let’s see what will happen next week!