Two finance questions: interest rates and hedging

Factual Questions
1

Hi there. Two bits of basic finance ignorance:

[ol]
[li]When people say that central banks reduce interest rates, does that mean the rate at which private banks borrow from the central bank, or the rate at which the central bank borrows (via bonds and such)?[/li]
[li]Why doesn’t ‘hedging’ your bets (betting the opposite way to protect against losses) also cancel out gains? Say I bet the dollar will continue its collapse, but hedge this with a bet that it will rise. If the dollar does continue downwards, won’t the second bet cancel out gains from the first?[/li][/ol]

Thanks!

tokaido-hokuriku

2

Generally, it means the rate at which the big private banks borrow from the central bank. In the US, there are actually a few different rates that the Fed can tweak, such as the primary and secondary overnight lending rates.

Yes, if your hedge and your bet are for the same amount. But suppose you are 20% sure the dollar will fall and 80% sure it will rise. You can take a large long position on the dollar and a small short position as a hedge. If the dollar does fall, you make a profit on your short position, which lessens the pain of the bigger long position. If it rises, you make money on the long position while the short fails. In this scenario, you must also consider that the potential gain in the long trade is infinite, while the potential gain in the short is finite. (The dollar can’t go below zero, after all, and if it does you probably have bigger problems to worry about.)

3

But that’s equivalent to a single long position. It’s not really a hedge.

A hedge is when you take opposite positions in related instruments. A common scenario: You think that XYZ Corp. is going to really outperform it’s competition in the widget market because of a new patent they have. So, you buy up lots of XYZ stock. But, what if reports come out that widgets are bad for you? Then all widget stocks, including XYZ, will go down in value. To protect against that, you take a balancing short position in a widget fund – some composite of the entire widget market – such that the movement of the widget market as a whole cancels between your long (XYZ) and short (market) positions. Then, all your portfolio is exposed to is the relative value of XYZ within the widget market, regardless of what the market as a whole does. This hedge protects you from fluctuations in the latter. (It’s true that if the whole widget market goes up, you’ve “lost” profit, but it could have gone down, too, and that’s not what you were trying to bet on anyway.)

4

That’s a good point. This is why I stick to index funds.

5

The Central Banks do not raise or lower rates.

They set a target rate they would like to see commercial banks lend to each other their reserve balances kept at the Fed. To achieve this target they expand or contract the supply of money. To expand they print up some dollars and exchange it for treasuries and other collateral from banks. More money is floating around the system therefore it is less scarce and cheaper to get i.e. lower rates. They raise the target rate by doing the opposite.

Fed daily lending

In the link above you can see what they take as collateral every day, the rate they charge, and what the banks try to get them to take.

I haven’t noticed it much this month but sometimes they have an announced target rate but lend at rates that are quite different. If they are charging more than the announced target rate it is known as “defending the dollar”, or the value of a dollar. The reason this is important to us regular folks is that all of the above sets the value for the dollar. If the dollar is worth less we pay more for imports such as oil and DVD players and inflation rears its ugly head.

That’s why sometimes when the fed “cuts rates” treasury rates, mortgage rates and credit card rates tend to go up. They are longer term and investors are afraid to hold long term debt when inflation is on the horizon.

Its a delicate balance and a very tough job figuring out what to do.

A pretty neat 1 page chart explaining who they lend to.
For extra credit here is a chart showing the crap they now take as collateral for longer term loans.
2 page pdf

Take note of the third column titled ‘Lendable Value for Securities or Instruments if Market Price Not Available’. This is also known as tier 3. Crap so crappy no one wants to buy it. The crappiest. Best guesses are that its worth between 30 and 50 cents on the dollar but the Fed will do you much better than that. Like a pawn shop from heaven!
And for extra extra credit we have one more.

Another Fed puzzler

In the first chart please turn your attention to the columns on the left labeled Non-Borrowed and Required.

This shows the amount that banks are required to have in reserves with the Fed. For years and years this went along, with what was required closely matching what was on hand (somewhere I have the data for the last 50 years). Everything changed this past December when the banks were a little short, they only had 27 billion of the required 40.

The next month we went to a negative number. :eek:

A negative non-borrowed reserve number. That means not only did the banks not have any reserves but they had to borrow some extra to cover what, lunches? Picking up the dry cleaning?
And that number has been growing steadily since.
Can you tell I’m fun at parties?