Friday 14 November 2008

Overnight rate

The overnight rate is generally the rate that large banks use to borrow and lend from one another on the interbank market. In some countries (for example, Canada), the overnight rate may be the rate targeted by the central bank to influence monetary policy. In most countries, the central bank is also a participant on the overnight lending market, and will lend or borrow money to some group of banks.

There may be a published overnight rate that represents an average of the rates at which banks lend to each other; certain types of overnight operations may be limited to qualified banks. The precise name of the overnight rate will vary from country to country.

Background
Throughout the course of a day, banks will transfer money to each other, to foreign banks, to large clients, and other counterparties on behalf of clients or on its own account. At the end of each working day, a bank may have a surplus or shortage of funds. Banks that have surplus funds may lend them to or deposit them with other banks, who borrow from them. The overnight rate is the amount paid to the bank lending the funds.

Banks will also choose to borrow or lend for longer periods of time, depending on their projected needs and opportunities to use money elsewhere.

The overnight rates are fixed every month and at different point of time each month by different countries.


Measure of liquidity
Overnight rates are a measure of the liquidity prevailing in the economy. In tight liquidity conditions, overnight rates shoot up. Overnight rates may also shoot up due to lack of confidence amongst banks, as was observed in the liquidity crunch of 2008.

In order to measure liquidity situation, the spread between risk-free rates and overnight rates is considered. The TED spread is a liquidity indicator for US, which is the difference between LIBOR and Treasury bills. (From Wikipedia, the free encyclopedia)

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