Foreign Exchange: A Practical Guide to the FX Markets

CHAPTER 3

Interest Rates

WHAT ARE “INTEREST RATES”?

An interest rate is the price of money. Economists may talk about interest as the reward that accrues to foregone consumption, which could be argued, I suppose, at some level, but, in the end, the interest rate is simply the cost of borrowing money or the return from investing or depositing money. The nice thing about defining the interest rate as the price of money is that you don’t have to specify whether it is a rate for borrowing (a cost) or a rate for lending (a benefit), though, as with every price in the financial markets, you should be prepared to encounter a bid-ask spread in the world of interest rates as well.

In Chapter 2, we defined every price as a ratio of quantities. When I think of an interest rate, I usually think in terms of percentages. For example, we might say that the interest rate is 5.20%. Where does the notion of price as a ratio come into play here? Let’s say you wanted to host a party for a group of your friends celebrating the recent successes of your favorite sports team. If you wanted to serve food and beverages, you’d need to spend some money. If you did not have any cash readily available, you could, in principle, go to the bank and borrow some money. The banker would ask you how much money you’d like, would check your credit rating, would ask you to fill out and sign several forms, and then would ultimately quote you a rate of interest, say, 5.20%. If you decide to borrow USD 100 today, then ...