Question

Reverse Repurchase Agreements

On 3 February 2020, China’s central bank, the People’s Bank of China (PBOC), conducted the largest single-day reverse repo operation in its his- tory. The PBOC injected a total of 173.81 billion USD into the money mar- kets through reverse bond repurchase agreements, which is the purchase of bonds with the agreement to sell them at a higher price at a specific future date. Use a diagram showing the exchange rate, the expected currency re- turns, and money holdings to describe the short-term and long-term effects (i.e., flexible prices) of this monetary policy action from the perspective of the United States. That is, let USD be the domestic currency and CNY be the foreign currency (10 Points).

Answer 1

Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.

In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, it's the other way around. The domestic currency is the base and the foreign currency is the counter.

The convention is to make interest rate quotes as a direct quote - which in your example means that the EURO is the domestic quote. For example, saying “1.2 Euro per dollar gives you the price of the dollar… which is what a European would be interested in. This is expressed as USD:EURO. It could also be said in the industry that the dollar is the quoted currency when expressed in this fashion.

It’s like a price label in a store that says GBP 0.88/Box, you can buy one box for GBP 0.88, or if you have one box you can sell it for GBP 0.88.

If they had said: Bid = GBP 0.88/Box, Ask = GBP 0.89/Box, then

1. You can buy one box of fruit for GBP 0.89, or

2. You can sell them one box of fruit for GBP 0.88/Box

So using the “bad” direct/indirect terminology, GBP 0.88/Box is the direct quote or direct price for buying 1 box. So when you go to the store, the direct quote is what they are showing as the price for one bo, i.e., it’s the direct quote for buying/selling one box.

If next day you go to the store and tell them you want to buy one GBP, they are going to think you are crazy until they realize you’re a CFA geek and you really mean you want to sell them one box and walk awy with some GBP! In that case, the price of one GBP is not obvious “directly”, hence it is indirectly obtained from GBP 0.88/Box, or 1.14 Box/GBP, so you have to give them 1.14 boxes to walk away with one GBP