How Does the Federal Fund Rate Work?

What follows is a transcript of the video.

Let’s try a practice question

For an investor expecting the federal fund rate to fall, which of the following investments would be most appropriate?

A. Treasury bills

B. Treasury notes

C. Treasury bonds

D. Commercial paper

The correct answer here is C.

What type of bond will increase as interest rates fall?

This requires a little bit of knowledge about fixed income securities. If you’re not sure, this is a good opportunity to just guess. The best answer for this one is going to be C. Let’s break it down.

The best way to think about the federal fund rate is that it’s just an interest rate. So, they’re basically telling you that interest rates are falling. If interest rates are falling, what do we know about bond prices? Keep in mind that inverse relationship: As interest rates are going down, bond prices are going up. If rates are going down, prices are going up. What they’re asking you, essentially, to word this question a little bit differently, is, which type of bond is going to increase the most as interest rates fall?

What makes a bond more sensitive to changing rates?

There are two key factors that make a bond more sensitive to changing rates. Does anyone remember what those key factors are? What makes bonds more sensitive or more volatile to changing rates? What type of bonds specifically are more susceptible to interest rate risk? The key thing is to break it down here. Which kind of bonds are going to be more volatile? Long-term bonds and low coupon bonds. Long-term low coupon bonds, including zeros, would be the most volatile.

If you think about the different Treasuries, which of these three Treasuries is going to have he longest term? Treasury bonds are 30 years, while notes are between two to 10 years. Bills are a year or less. Because Treasury bonds are the longest term, they’re going to be the most volatile. And as rates fall, because they’re the most volatile, they’re going to increase the most in price.

What is the Fed funds rate?

The fed funds rate is the rate that banks charge one another for overnight loans. For a question like this, think about it just as a proxy for interest rates in the market. You can assume that the Fed funds rate is declining. Other rates would also be declining and vice versa.

What is the maximum maturity of commercial paper?

One more follow-up question, commercial paper. Commercial paper is an example of a money market security. Does anyone remember the maximum maturity of commercial paper? It’s a good testable point to note for the exam. For commercial paper, 270 days is the maximum mature. Why 270 days, by the way? Because if it’s 270 days or less, it’s an exempt security. It doesn’t have to be SEC registered. The 270 days, that’s a good day count.