Question

2. What exactly is the Fed Funds Rate, and why isn’t it considered a “tool of monetary policy?

2.1Define and discuss interest rate risk. What are the two risk components of interest rate risk and how do these interact with each other?

2.2Explain how and why the U.S. forward exchange rates are related to short-term interest rates in the United States and Germany.

Answer 1

2. Federal fund rate is the rate that banks charge from each other for transacting the Federal Reserve funds overnight.it is not considered a tool for monetary policy as it is a dependent factor upon the interest rate that has been changed by the Federal government.

When the Federal Reserve changes their monetary policy it automatically changes according to the monetary policy of the fed like when Federal Reserve cut interest rate to almost zero percent in the recent covid-19 outbreak the fed fund rate automatically came down because of the rate of credit card, bank loans ,mortgages etc.

2.1.Two components of interest rate risk are price risks and reinvestment risk .Price risk means the risk when the interest rate rises and the prices of the bond fall relatively. Whereas the reinvestment risk means the decrease in amount of cash flows due to increase in interest rates like when the interest rates increases the relative value of cash inflows related to and investment goes down so the value of investment decreases.

both types of risk interact with each other as which one goes down the other go down as well like when the interest rate rises ,price risk goes up and relativity the reinvestment risk also go up

2.2 this is interrelated because of a theory known as interest rate parity. This theory advocates that the depreciation in exchange rates value will be countered by appreciation in the currency value due to increase in purchasing power so overall effect of the decrease in value of currency will be negated by increasing value of purchasing power.

For example when the interest rates in America goes down,value of dollars also depreciates but the purchasing power of dollar increases so that effect remains Nil due to the theory of interest rate parity.