Academic journal article The International Journal of Business and Finance Research

Integration of Key Worldwide Money Market Interest Rates and the Federal Funds Rate: An Empirical Investigation

Academic journal article The International Journal of Business and Finance Research

Integration of Key Worldwide Money Market Interest Rates and the Federal Funds Rate: An Empirical Investigation

Article excerpt

ABSTRACT

This study investigates whether there is an increased integration of U.S. domestic money market interest rates and the Eurodollar market interest rates following two important changes that the US Federal Reserve (the Fed) implemented. First, elimination of reserve requirements on Eurodollar bank deposits in the early 1990s. Second, change in the operating procedure for conducting monetary policy in early 1992 from borrowed reserves targeting to federal funds rate targeting. The money market interest rates are three and six month Eurodollar London Interbank Offered Rates (Libor), three and six month U.S. Treasury bill (T-bill) rates, and the effective federal funds rate. Cointegration and error-correction methodology of Johansen and Juselius (1990,1992) is employed for this empirical study. Results indicate that integration of the five interest rates increased following the two changes by the Fed. It is the effective fed funds rate and the three-month T-bill rate that participate in the adjustment process back to their equilibrium path following an external shock to the system. Granger causality tests produced different and somewhat conflicting results when the error-correction model is estimated with and without the federal funds rate in the system. This finding requires further study and investigation.

JEL: C32, C58, E43, G15

KEYWORDS: Libor, Unit Root, Cointegration, Granger Causality

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The primary objective of this study is to examine whether there is an increase in the integration of U.S. domestic money market interest rates and the offshore Eurodollar London interbank offered rates (Libor) since 1990 following two important changes made by the U.S. Federal Reserve (the Fed). First, a regulatory change eliminating reserve requirements on Eurodollar liabilities of offshore banks in early 1990, and second, change in the Fed's operating procedure for conducting monetary policy switching from borrowed reserve targeting to federal (fed) funds rate targeting in early February, 1992. The money market interest rates used in this study are the three and six month U. S. Treasury bill (T-bill) rates, effective fed funds rate, and the offshore three and six-month Libor. To my knowledge there is no published study that exclusively investigated the relationship between the domestic and offshore rates after the monetary policy regime change to fed funds targeting in early 1992.

The relationship between U.S. T-bill yields including the effective fed funds rate and the Libor of different maturities is examined employing cointegration and error correction methodology developed by Johansen and Juselius (J J) (1990, 1992). The choice of methodology to examine the relationships is supported by several similar studies summarized in Hall, Anderson, and Granger (1992).

These money market rates play a very important role in influencing various other interest rates. For instance the three month T-bill rate is a prominent default-risk-free rate in the U.S. and often used as a proxy for a risk-free asset as well as a benchmark lending rate. Likewise, according to some estimates, the value of financial contracts linked to the Libor is over $3 trillion. The Eurodollar market and the fed funds market are located in different places but the currency in both the markets is the U.S. dollar. The volume of transactions in the Eurodollar interbank market is larger than the U.S. fed funds market. Further, according to Baba et al (2009) European banks had substantially increased their U.S. dollar asset positions from about $2 trillion to over $8 trillion by mid-2007. The effective federal funds rate is considered a 'bellwether' rate leading all short-term rates. The effective fed funds rate is the weighted average of the funds rates that prevailed during the day. The weights are the amounts of funds traded at different rates during the day.

During the financial and banking crises in the U. …

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