Define Call Rate:

"The term "call rate" refers to the interest rate at which banks and financial institutions can borrow funds from the central bank or from each other on an overnight basis."

Explain Call Rate:

Introduction

The term "call rate" refers to the interest rate at which banks and financial institutions can borrow funds from the central bank or from each other on an overnight basis. It is a short-term interest rate used in the money market and is typically applied to loans with a very short maturity period, often just one day.

Key points about call rate:

1. Overnight Borrowing: Call rate transactions involve borrowing and lending funds for very short periods, usually for one day. The loans are typically unsecured, meaning that they do not require collateral.

2. Money Market: The call rate is a key benchmark in the money market, where financial institutions manage their short-term liquidity needs and maintain their reserve requirements.

3. Central Bank Role: In some countries, the central bank plays a significant role in the call rate by setting a target rate or a policy rate, such as the federal funds rate in the United States or the repo rate in India. The central bank's actions influence the overall money supply and interest rates in the economy.

4. Interbank Transactions: Banks with excess funds can lend to other banks that need short-term funds to meet their reserve requirements or to manage temporary liquidity shortages. The rate at which these transactions occur is referred to as the interbank call rate.

5. Indicative of Market Conditions: The call rate is a sensitive indicator of the prevailing market conditions and reflects the supply and demand dynamics in the money market. It can fluctuate based on factors such as changes in monetary policy, liquidity levels, and market expectations.

6. Comparison to Policy Rate: In some cases, the central bank's policy rate (e.g., the target interest rate) serves as a reference point for the call rate. Financial institutions may aim to keep their overnight lending rates close to the central bank's target rate.

Example:

In a particular country, the central bank sets the call rate as its policy rate. The current call rate is 2.50% per annum.

Scenario:

1. Overnight Borrowing: Commercial banks and financial institutions in the country engage in interbank borrowing and lending to manage their short-term liquidity needs. Bank A needs to borrow funds on an overnight basis to meet its reserve requirements and to cover temporary cash shortfalls.

2. Interbank Transaction: Bank A approaches Bank B, another commercial bank, for an overnight loan of $1 million.

3. Call Rate: Bank B agrees to lend the funds to Bank A and quotes a call rate of 2.50%. This means that Bank A will pay an annual interest rate of 2.50% on the $1 million borrowed for one day.

4. Interest Calculation: The interest for the overnight loan is calculated as follows:

   Interest = (Loan Amount x Call Rate) / 365 Interest = ($1,000,000 x 2.50%) / 365 Interest ≈ $68.49

5. Repayment: The next day, Bank A repays the $1 million loan along with the interest of approximately $68.49 to Bank B.

The call rate in this example is 2.50% per annum, which translates to a daily rate of approximately 0.0068493% (calculated as 2.50% / 365 days). Bank A borrows $1 million from Bank B for one day and pays an interest of approximately $68.49 based on the call rate.

Conclusion

The call rate is an important tool for central banks to influence short-term interest rates and implement monetary policy. By adjusting the call rate, the central bank can influence borrowing and lending activities in the money market, thereby affecting overall economic activity, inflation, and interest rates throughout the economy. 

Additionally, the call rate serves as a benchmark for various other short-term interest rates, such as the prime rate and the discount rate.