by A.W. Berry

Created on: January 03, 2009

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. For example, 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

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