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Difficulty: Very hardInterest Rate Dynamics and Yield Curve Analysis

Under typical economic conditions, benchmark interest rates in the U.S. financial system follow a distinct hierarchy determined by Federal Reserve policy, bank borrowing costs, and credit risk premiums. Arrange the following benchmark interest rates in order from lowest to highest rate.

  1. 1Federal Funds Rate
  2. 2Discount Rate
  3. 3Broker Call Rate (Call Money Rate)
  4. 4Prime Rate

Answer

The correct order from lowest to highest rate is: Federal Funds Rate, Discount Rate, Broker Call Rate, and Prime Rate.
In standard market conditions, the hierarchy of short-term benchmark rates from lowest to highest reflects the progression of credit spreads and administrative target rates: Federal Funds Rate (lowest) < Discount Rate < Broker Call Rate < Prime Rate (highest).

Step-by-Step Solution

1
Identify the baseline interbank overnight borrowing rate
The Federal Funds Rate is the lowest rate because commercial banks lend excess reserves to each other overnight on an uncollateralized basis at this target rate set by the FOMC.
It represents the core fundamental cost of overnight money in the banking system.
2
Determine the position of the Federal Reserve's lending rate
The Discount Rate is set higher than the Federal Funds target rate (typically 50 basis points above the upper bound).
The Fed sets the discount rate higher to act as a penalty rate and encourage banks to seek liquidity in the open interbank market first.
3
Evaluate bank lending rates to broker-dealers for margin financing
The Broker Call Rate (Call Money Rate) ranks above the discount rate but below the prime lending rate.
Banks charge broker-dealers this short-term rate for collateralized margin loans, incorporating a small spread over interbank borrowing costs.
4
Identify the commercial bank rate for corporate borrowers
The Prime Rate is the highest rate among the four options.
Commercial banks base their prime rate on the Fed Funds rate plus a profit spread (traditionally Fed Funds + 3%), making it higher than interbank and broker lending rates.

Key Concept

Hierarchy of U.S. Benchmark Interest Rates
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Topics

Interest Rate Dynamics and Yield Curve Analysis

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