Question

Non-bank financial institutions don't have access to the IORB rate. However, they can make overnight deposits with the Fed and earn the ON RRP rate. What happens if the ON RRP rate is 3.4%, the current federal funds rate is 3.9%, the IORB rate is 4.5%, and the discount rate is 6%?

Group of answer choices

a) In this scenario, there are no incentives for arbitrage.

b) Non-bank financial institutions will have an incentive to make loans in the federal funds market. Banks will borrow in the federal funds market and make overnight deposits at the Fed.

c) Non-bank financial instititions will borrow in the federal funds market so they can earn the ON RRP rate. This arbitrage will bring the federal funds rate into the target range.

d) Banks will borrow from the Fed at the discount rate and make loans in the federal funds market to non-bank instititions.

e) Through arbitrage, the ON RRP rate and the IORB rate will converge.

Answer 1

Non-bank financial institutions will be incentivized to lend in the federal funds market at rates between the ON RRP and the IORB rates, while banks will prefer to borrow in the federal funds market rather than at the higher discount rate, leading to a scenario where non-banks lend and banks deposit at the Fed overnight.

Step-by-step explanation:

If the ON RRP rate is 3.4%, the current federal funds rate is 3.9%, the IORB rate is 4.5%, and the discount rate is 6%, then non-bank financial institutions will be incentivized to make money through arbitrage.

Considering these rates, non-bank financial institutions have an option to make overnight deposits at the Fed and earn 3.4%. However, if banks are willing to borrow at a rate lower than the IORB rate they receive from the Fed but higher than what non-banks earn from the ON RRP, there's an arbitrage opportunity. On the other hand, banks will not choose to borrow from the Fed at the discount rate of 6% since it's higher than the rate at which they can borrow in the federal funds market (3.9%). Therefore, the correct answer is (b) Non-bank financial institutions will have an incentive to make loans in the federal funds market. Banks will borrow in the federal funds market and make overnight deposits at the Fed.