Hailey College of Banking

and Finance

FI
(How Interest Rates Set)
(BBA 7th Semester)
Instructor: Abdul Qadeer
dr.aqkhan@live.com
03336487274

How Interest Rates Set?

Each Month, the Bank of Englands Monetary Policy

Committee meets to set the Official Dealing Rate. This is
the rate at which the Bank of England is prepared to lend
to commercial banks.
In the US, the Federal Reserve Board sets the Discount
Rate at which commercial banks can borrow money from
Federal Reserve Board banks.
A loan from both the Bank of England and the Federal
Reserve Board to a commercial bank is regarded as safe:
the interest payments will be made and the capital will be
repaid. Hence, there is no additional premium in these
interest rates to cover the cost of default.
The Official Dealing Rate (in England) and the Discount
Rate (in the US) represent a minimum interest rate.

Monetary Policy Committee of

SBP

A Monetary Policy Committee (MPC) consisting of Governor

(or a Deputy Governor nominated by the governor in his
absence), three senior Executives of the SBP, three members
of the Board and three external members who shall be
economists and appointed by the government on
recommendations of the Board was established to formulate,
support and recommend the Monetary Policy Statement and
other monetary policy measures.
The main objective of this committee was to enable the SBP
to perform its essential functions in a professional way in a
changing and emerging financial environment.
http://www.brecorder.com/editorials/0:/1248051:the-amendedstate-bank-of-pakistan-law
/

Business and public borrow money from the commercial banks

and other institutions. The interest rate quoted by the
commercial banks are often called base rates and loans from
commercial banks to small business and the public are set in
relation to base rate. But now there is a risk of default on the
payments.
The interest is low with high creditworthy institution and high
for a low creditworthy institutions. So the commercial banks will
charge a number of percentage points above base rate. For a
creditworthy institution, this might be 2-3 percentage points
above base rate; for a loan to which a large amount of risk is
attached, this could be 8-10 percentage points above base rate.
So if the base rate was 5%, a creditworthy company/individual
might pay 7% or 8% on their loan. A borrower with a poor credit
history might pay 13% to 15% or more.

Sometime, the percentage is expressed in basis points.

One basis point is 1 / 100th of 1%. So 0.5% above base
rate might be described as base rate plus 50 basis
points
Banks will not extend the same interest rate to
investors and borrowers. The rate they will pay to those
depositing funds in the bank is called bid rate. The rate
they will charge for lending money is the offer rate. The
bid rate will be lower than the offer rate.

The Libor rate

Large international banks are heavily involved in lending

and borrowing money in all currencies from other large
international banks. The rate used in these transactions is
based on the LIBOR rate (London Interbank Offered Rate).
LIBOR is the rate at which banks can borrow money from
other banks in the London interbank market. Since there is
a small risk of default in these transactions, LIBOR rates
will be above the Official Dealing Rate. But banks are
usually more creditworthy than small businesses and
private citizens so LIBOR will be below those rates offered
by commercial banks.
The LIBOR rate is set by the British Bankers Association
(BBA) at 11:00 am on each business day. LIBOR is the most
widely used reference rate for short term interest rate.

It is used as the basis for the settlement of interest rate

contracts on many of the worlds major futures and
options exchanges.
The table below gives LIBOR rates for 27 July 2004.
Maturity

Interest
Rate

Over Night

4.66125

One month

4.72000

Three
months

4.91875

Six Month

5.08625

One year

5.3375

To set the LIBOR, the British Bankers Association,

acting with the advice of senior market practitioners,
refers to a panel of at least eight contributor banks.
These banks are chosen to reflect the composition of
the market. In selecting its panel, the BBA might
consider a banks reputation, expertise, size of market
activity and in particular the involvement of the bank in
the currency whose LIBOR rate is to be determined.
BBA LIBOR rate are set daily for nine international
currencies: pound sterling, US dollar, Japanese yen,
Swiss franc, Canadian dollar, Australian dollar, euro,
Danish krone and the New Zealand dollar.

The LIBOR rate is quoted in the financial press as

annual rate.

So if the one-month LIBOR rate is 4.72000% then on an

investment of 10 000, amount after one-month
= 10000 [1+ 0.0472*1/12] = 10039.33
If the three-month LIBOR rate is 4.91875% then amount
after three months = 10000 [1+3/12 * 0.0491875] =
10 122.97
Day Count Conventions: page 149 to 152.