Last week the Federal Reserve announced that it would raise the discount rate by 25 basis points to 0.75 per cent. But what is the discount rate? According to the Federal Reserve Board, it is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility – the discount window.
The Fed has three discount window programmes available: primary credit, secondary credit and seasonal credit. Each window has its own interest rate. Under the primary credit programme, which is the Fed’s main discount window, the Fed extends funds to solid institutions for a very short period of time, usually overnight. The primary discount rate is set above the usual level of short-term market interest rates and it is this that the Fed normally refers to when it talks about the discount rate.
Institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. The rate for secondary credit is therefore higher than the primary discount rate and it is currently at 1.25 per cent.
This ratio measures the risk adjusted return of a portfolio of assets. To calculate the Sharpe ratio, first subtract the risk free rate, such as the yield on a 10-year US Treasury bond, from the return on the portfolio. The next step is to divide the real return by the portfolio’s standard deviation.
The Sharpe ratio is a good way of judging whether a portfolio’s returns are due to good investment decisions or because the portfolio manager has taken excess risk. The higher the Sharpe ratio the lower the risk of the entire portfolio. This is because the denominator in the calculation – the standard deviation of portfolio returns, which is a measure of risk – is low.
A good fund manager will provide the highest yield for the lowest risk, this is why Sharpe ratios are a good measure of performance. A negative Sharpe ratio indicates it would have been more profitable to invest in a risk free asset such as US Treasuries.