Foundations of Finance and Investment

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The Monetary Policy Committee (MPC) of the Bank of England (BOE) decided in April to keep the Repo rate at 4.50% (BOE, 2006). Forecasts by over forty City and non-City financial institutions showed a rate lower by 25 basis points at year-end, with a median forecast of 4.25% (HMT, 2006).


The Repo rate is the short-term interest rate at which financial institutions such as banks and building societies can borrow money from the BOE for a two-week period. The MPC meets monthly to set the Repo rate as part of its monetary policy function to control inflation. Its decision on what this rate should be acts as a signal to the money markets of how much to pay savers and charge borrowers for the use of money. The Repo rate therefore acts as the baseline for the cost of money that can be loaned to customers, which can include other banks, in the form of mortgages and overdrafts (BOE, 2005).
Many households and firms, however, borrow for longer time periods and prefer to fix borrowing costs in advance, either because this helps them plan their cash flows better or protects them from the future risk of rising interest rates. This is a gamble some lenders and borrowers take, since interest rates may also move the other way. Fixed long-term borrowing or interest rates are relevant to those who want fixed-rate mortgages for housing or to firms with long-term investment plans like expanding a factory that needs some years to pay off. Long-term interest rates ranging from one to ten years are calculated simply by taking an average of forecast short-term interest rates over the desired period.
Short- and long-term interest rates are closely related, but differ on the basis of MPC decisions; the expectations of h ...
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