Explaining the Overnight Interest Rate

The overnight interest rate is quite simply, the cost of borrowing money from financial institutions over a short amount of time. Overnight interest rates are set by large national banks such as the Federal Reserve and the London Inter Bank Offered Rate (LIBOR), however loans in the form of commercial paper i.e. inter-corporate loans may also quote overnight or short term interest rates which can be used overnight.

Both federal and commercial overnight rates can be found in the "money rates" section of financial newspapers such as The Wall Street Journal. Overnight interest rates can vary from less than 50 basis points or half a percent to over 200 basis points or 2 percent depending on which country or economic zone the loans are originated in. This article will discuss 1) the purpose of overnight interest rates in terms of the loans they are used for, and 2) how overnight interest rates are determined.

What overnight loans are used for

Since the overnight interest rates can be quite low and money may only be needed for a short period of time, overnight federal or commercial loans can be an ideal source of financing. The reasons why financial institutions acquire these loans can depend on the financial circumstances the institutions find itself in.

If a Government audit is about to be made to ensure sufficient reserve requirements, a bank might take an overnight or short-term loan to meet legal specifications. Other reasons may include, affecting liquidity ratios for financial statements, liquidity reports, acquisitions for which money can be quickly reacquired to pay the loans and hedges against other loans such as in the case of overnight index swaps (www.tradingmarkets.com) Reasons overnight loans are taken are listed below.

• Improve liquidity positions
• To fund short-term acquisitions and/or stabilize cash flow
• Conversion via swaps to bypass new loan processes
• Hedging of interest rate risk on other loans via swaps
• Improve financial statements and financial ratios
• For overnight positions/loans in Foreign exchange markets

How overnight interest rates are determined and change

Government or regulatory determined interest rates are based on economic conditions within financial markets. That is to say, these interest rates are adjusted to ease or tighten the accessibility of money to financial institutions for economic reasons such as inflation and economic growth. (useconomy.about.com) In the case of commercial paper, the rates are also determined by the Federal reserve in the United States. (federalreserve.gov) This means, the central bank makes decisions about how much it will cost corporations to lend and borrow from one another.

However, unlike the federal overnight interest rate, commercial paper interest rates are calculated and utilized for different purposes, specifically to harmonize interest rates offered by multiple corporations based on credit ratings, collateral, solvency and rate differences. (federalrserve.gov) In other countries, the purposes and/or methods of determining overnight interest rates may vary. For example, in Europe, overnight interest rates have been significantly higher than in North America are set at such rates to meet the financial and economic needs and goals of that economic block.

Summary

In summary, overnight interest rates are the costs incurred to borrow money from other financial institutions whether those loans be acquired from banks or FOREX traders. In the case of lenders, the overnight interest rate specifies the amount those lenders are able to lend at overnight.

Overnight loans are used for a number of purposes hence the need for interest rates on such loans. The interest rates for these loans tends to be lower than longer term loans and is determined using particular economic, and financial goals such as economic growth, borrower risk and inflation. Overnight interest rates are a key part of the domestic and international financial system and help provide liquidity and suitable cash availability for the financial and economic needs of that financial system and its various markets.

Sources:

1. http://www.investopedia.com/terms/o/overnightrate.asp?viewed=1
2. http://www.investopedia.com/terms/l/libor.asp?viewed=1
3. http://tinyurl.com/6doeq4y
4. http://www.traderslog.com/forex-interest.htm
5. http://useconomy.about.com/od/interestrateindicators/p/interest_rate.htm