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Difficulty: MediumInterest Rate Dynamics and Yield Curve Analysis

Under standard economic conditions, key benchmark interest rates in the United States financial system follow a distinct hierarchy based on credit risk, liquidity, and central bank policy settings. Arrange the following benchmark interest rates in order from lowest to highest rate.

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

Answer

The correct order from lowest to highest interest rate is: Federal Funds Rate, Discount Rate, Broker Call Rate, Prime Rate.
Under standard market conditions, benchmark interest rates increase as borrowing risk and commercial markups increase. The Federal Funds Rate is the lowest rate, representing overnight interbank borrowing. The Discount Rate is set slightly above the Federal Funds Rate target by the Federal Reserve to act as a backstop. The Broker Call Rate is higher, as commercial banks charge broker-dealers a premium for financing margin securities. The Prime Rate is the highest of the group, representing the base lending rate offered by commercial banks to premier corporate borrowers (typically set 300 basis points above the Federal Funds Rate).

Step-by-Step Solution

1
Identify the lowest benchmark rate in the monetary system.
The Federal Funds Rate is the rate commercial banks charge each other for overnight uncollateralized reserve loans and represents the baseline interest rate in the economy.
Because it applies to short-term interbank transfers of excess reserves, it carries minimal credit markup.
2
Determine the relative position of the Discount Rate.
The Discount Rate is set directly by the Federal Reserve Board above the Federal Funds target rate.
The Fed intentionally sets the Discount Rate higher than the Fed Funds Rate so banks seek liquidity from other commercial banks before requesting emergency loans from the Fed.
3
Evaluate bank lending rates to financial intermediaries.
The Broker Call Rate (Call Money Rate) sits above the Discount Rate and Federal Funds Rate.
Commercial banks charge this rate on call loans extended to broker-dealers to finance margin accounts, adding a commercial spread over interbank funding costs.
4
Identify the highest benchmark commercial lending rate among the choices.
The Prime Rate is the highest rate among the four options.
Commercial banks base their Prime Rate on the Federal Funds Rate plus a spread (typically 3 percentage points or 300 basis points) when lending to their most creditworthy corporate clients.

Key Concept

Hierarchy of Benchmark Interest Rates
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Topics

Interest Rate Dynamics and Yield Curve Analysis

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