The Volatility of Short-Term Interest Rates

By Nowak, L. Stone | Review of Business, Spring 1991 | Go to article overview

The Volatility of Short-Term Interest Rates


Nowak, L. Stone, Review of Business


The Volatility of Short-Term Interest Rates

The volatility of interest rates increased when the Fed changed its operating procedures in October of 1979 from an interest rate target to a reserves based target. Most studies attribute the increased volatility to the change in operating procedures [10,7,6]. Some suggest that other events may have caused the increased level of volatility of interest rates after October 1979 [1,6].

Numerous studies have shown that the increased volatility of interest rates has been detrimental to our economy [7,16,6,5]. Most studies concentrate on the volatility of long term rates but short-term interest rate volatility also creates problems. Volatility, on the other hand does present profit opportunities [2]. Since the Federal Funds rate is an indicator of Federal Reserve policy changes, slight fluctuations in the rate are often perceived or misperceived as indicators of tightened (or eased) Federal Reserve policy. Treasury bill prices move almost immediately with each tick of the funds rate; the effects spread to the long-term bond market, the stock market, the foreign exchange market, and the futures market as well. Volatility in the Federal Funds rate affects banks, thrifts, foreign bank branches, United States government agencies, security dealers, and other investors such as Federal Funds brokers.

The Federal Funds Market

Federal Funds loans to large commercial banks in the United States exceeded $35 billion per week in 1988, and Federal Funds loans to other specified investors exceeded $15 billion per week in 1988. Banks purchase or sell Federal Funds daily to meet their reserve requirements and to profit from their excess reserves. Dealers finance their inventories of securities with repurchase agreements whose rate is based on the Federal Funds rate.

Although most Federal Funds traders manage their reserve positions conservatively, trading sophistication is on the upswing. When Federal Funds rates were low and did not move much, only the largest banks with aggressive traders paid attention to maximizing profits on Federal Funds transactions or minimizing the cost of managing their reserve positions.

When rates became higher and more volatile (after October 1979), opportunities to profit from selling excess reserves improved. Not only big city banks, but also regional and smaller banks became interested in the Federal Funds market. Foreign bank branches and agencies have also become major players making up one-quarter to one-third of the volume.

Profit Opportunities

Many managers buy funds regularly regardless of price when they need reserves and sell their excess reserves to their correspondents at the opening price or at the effective yield without paying attention to the intra-day and intra-week movements. Aggressive managers with substantial volume can improve their performance especially when there is significant variation in the rates. Aggressive traders can wait to sell some of their excess reserves when they predict that the funds rate will go up, and conversely, those who need to buy can increase their buying and slacken off when the rates rise during the week.

Since one-sixteenth of one percentage point, 6.25 basis points, is only $1.74 on a one million dollar trade, the benefits from aggressive trading are only available to banks that deal in large volumes. For a bank that must acquire $500 million a day, one-sixteenth or one-eight of a point on a daily basis turns out to be a substantial saving: $500 million x $1.74 x 365 days = $317,550 per year for each one-sixteenth of a point. Small volumes (less than $10 million) are generally handled through correspondent relationships and do not warrant much attention to price, but traders of large volumes whether handled through correspondents or through Federal Funds brokers can try to take advantage of daily changes in rates. When the average daily change in rates is high (see table 2), it makes sense to pay attention to the price of the funds. …

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