Note to my readers: The articles on Alex Trueba’s account aim to help you understand various aspects of finance for better decision-making, and, more often than not, simplicity requires leaving details behind. The goal is to understand concepts, not to make a masterclass in economics or finance. The examples use simple numbers and don't reflect current market data, because the aim is to be practical, global, and as evergreen as possible.

As we begin our journey to understand the key concepts of finance and capital markets, there is no better way to start than with the rates that underpin most asset classes. They are key to understanding how money works and making better financial decisions. Be patient; it will make sense soon.

Before moving to our main topic, let’s define interest rates first: the price of money. Lenders surrender control of their capital temporarily and, in doing so, assume three main risks: tenor, credit, and inflation. By accepting the cost of money, the borrower gains present spending power it does not currently have and commits to returning the money plus interest within the established timeframe.

A nominal risk-free interest rate, meaning no credit risk (as markets usually treat US Treasury securities), has two main components: inflation and the real rate. One should say, “inflation and real rate expectations,” but let's leave it at that. The real rate is the actual growth of purchasing power, after accounting for inflation. 

Example 1: If inflation turns out to be 2.6%, a one-year UST bill yielding 4% would imply a real rate of 1.36%. You may wonder why it is not 1.4% by simple subtraction. The precise calculation uses the Fisher equation: (1 + 4%) ÷ (1 + 2.6%) − 1 = 1.36%. Simple subtraction is the common approximation and works fine when rates are low.

Central banks, inflation and reference rates

Central banks are generally tasked with maintaining price stability, usually by steering inflation toward a defined target. In the US, the Federal Reserve sets a target range for the federal funds rate (the Fed also has a mandate for maximum employment). In Mexico, Banco de México (Banxico) uses the “Tasa Objetivo.” In Europe, the European Central Bank (ECB) uses the Deposit Facility Rate. And so on. It’s fair to say that market rates in each system are anchored to the relevant policy rate, while also embedding term, liquidity, and credit risk.

The rationale for these rates is to establish a reference against which short-term rates trade, thereby influencing the economy’s overall cost of credit. Oversimplifying, if the economy is overheating and inflation is rising, the central bank will raise interest rates to make borrowing more expensive and curb inflation. If the economy is cooling down and inflation is dropping, the central bank will cut rates to support demand and prevent inflation from falling too far.

Benchmark market rates

Rather than being set by a central bank as reference rates, the benchmark rates are calculated from real market transactions between financial institutions (and, in some cases, quotes or estimates) within the same jurisdiction. They reflect the actual cost of money in a single currency. They serve as the baseline for pricing loans, mortgages, and derivatives.

In the US, SOFR (Secured Overnight Financing Rate) is the US dollar benchmark that tracks the cost of borrowing cash overnight, collateralized by US Treasuries. In Europe, Euribor (Euro Interbank Offered Rate) is the rate at which wholesale funds in euros can be borrowed unsecured (no collateral) in the European money market, for maturities ranging from one week to twelve months. In euros, the overnight benchmark comparable to SOFR is €STR; Euribor remains the main benchmark for term loans and mortgages. In Mexico, TIIE (Tasa de Interés Interbancaria de Equilibrio) is the Mexican interbank rate, calculated daily by Banxico, reflecting interbank money market conditions in pesos.

The calculation methodologies differ. For this exercise, there is no need to go into further detail; the relevant point is that countries have their own benchmark rates, which serve as the baseline for most financial products in their jurisdictions. There are usually terms for these rates, ranging from overnight to a year. These rates are closely related to inflation and expectations.

Why is this important?

Benchmark rates are a first step toward understanding financial interconnections and market dynamics, and even identifying risks. Let me explain with a few examples.

Example 2: A central bank sets a policy rate; overnight benchmarks and their term rates adjust; banks' lending rates add credit and term spreads; and corporate and consumer rates are set.

Straightforward, right? Once you understand the dynamic, it is. Of course, this article leaves out a lot of detail, but at the most basic level, this is it.

Example 3: Let’s say you are in Mexico. The 6-month TIIE is 7% (to simplify; new contracts in Mexico now reference the overnight TIIE de Fondeo, so strictly speaking this would be its 6-month equivalent), and the 6-month Cetes (Mexican T-Bills, considered risk-free in the country) are 6.50%. Someone random offers you a “great investment opportunity,” paying 20% unsecured over the same 6-month period. All rates are annualized.
What will you say?

For me, someone offering to pay 20% for a 6-month credit, about three times the benchmark rate, is either desperate for funding, unaware of what money costs, shut out of the banking system, or ill-intentioned. All red flags.

Example 4: Assume TIIE in Mexico is at 7% and US SOFR at 3.70% in the same tenor; the difference is 330 basis points, right? This spread drives the carry trade, closely followed by many international investors active in peso-denominated securities. The spread varies with economic conditions in both countries. The wider it gets (the larger), the more of these investors will be attracted to buy liquid, short-term securities in Mexico. The tighter it is (the smaller), the more likely these investors are to stop buying or sell holdings to take profits. Of course, these transactions still carry foreign exchange risk, but for now, let's leave it at that.

What else does this spread implicitly say? This spread is very useful in Mexico because it reflects the two countries' relative monetary policy stances in real time, potentially signaling Banxico’s commitment to its mandate and affecting the pricing of Mexican securities. It can also serve as an exchange-rate indicator between the countries’ currencies and as a benchmark for foreign-exchange derivatives.

Additionally, it has an implied relation with Mexico’s sovereign and credit risk premium, and it affects the cost of hedging (tenor-dependent) for Mexican corporates that borrow in one currency and earn in the other, whether they issue in Mexico or in US markets, using derivatives known as FX forwards and cross-currency swaps.
Do these spreads apply across countries? Yes.

Conclusion

Banks often tell their employees they are the first line of defense for the business; well, when it comes to your finances, you are.

I’m a huge believer that common sense, combined with knowledge and understanding, is the best starting point for decision-making. That's why I’m doing this: to give you the basics so you can build a healthier financial life.

To make these articles as user-friendly as possible for people with diverse backgrounds and even nationalities, I’m oversimplifying many concepts and skipping many details; always keep this in mind. For financial decisions, consult a licensed advisor in your country of residence.

I trust your patience paid off.

Alex