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After a little research on interest rates of different countries I figured out that they are more complicated than I thought and the meaning of them varies country by country.

For example, the U.S. rate, that has just been rised to 0.5%. Global-rates.com states:

When reference is made to the US interest rate this often refers to the Federal Funds Rate. The Federal Funds Rate is the interest rate which banks charge one another for 1 day (overnight) lending. This American base rate is set by the market and is not explicitly laid down by the FED. By withdrawing or adding funds to the money supply the FED tries to bring the effective federal funds rate into line with the interest rate that it is striving for. If the FED’s monetary policy alters the base rate, that usually affects the interest rate on various products such as mortgages, loans and savings.

So, the U. S. interest rate is the FED Funds Rate, which is not an actual (effective) rate, but rather a target rate, set by The Federal Open Market Committee (FOMC).

Wikipedia defines federal funds rate as following:

In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight.

Thus, FED Funds rate is also an overnight rate.

What does it really mean mathematically for FED Funds rate to be 0.5 %? If it is annualized (overnight -> annual), in what way exactly? Is the simple interests formula (R = i * t) used, meaning that FED really wants an actual overnight rate to be 0.5% / 365 (365 days in a year)? Or maybe the compound interest – R = (1+ i / n)n – is used? If so and if compounding period would be one day (is it in this case?), we'd find an an actual interest rate that FED wants to be by solving equation 0.5 = (1*x/365)^365.

Thank you in advance.

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Fed Funds are quoted on an annual basis so 0.5% means half a percent per year. The day count convention used is Actual/360 (note the use of 360, not 365 or 365.25. This old convention is common to many US money market instruments). So if you borrow 1 USD for a single day you would pay 0.005/360 in interest.

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  • $\begingroup$ What about European Central Bank (ECB) Main Refinancing Operations (MRO) (which is 1-week and currently 0.05%) rate? Is that quoted also as annual rate using simple interest? $\endgroup$ – Kristijonas Lukas Bukauskas Dec 18 '15 at 15:26
  • $\begingroup$ Yes, and the the Eurosystem also applies the day-count convention actual/360 in its monetary policy operations. So you pay 7*0.0005/360 to borrow 1 Euro for one week. $\endgroup$ – noob2 Dec 18 '15 at 15:57

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