Normally interest rates are related to loan instruments. One of the factors which decide interest rates is the term or duration of the loan. The loan term can be longer or shorter. The word “overnight” is related to the overnight market which is an important component of money market.
Generally speaking, the money market is nothing but the financial market at global level. It involves borrowing and lending of money on short term basis. Huge money players are involved like financial institutions including large banks and money dealers (e.g. mutual fund management) or some other clients dealing in credits. They all participate in borrowing or lending for short period. As a part or component of the global money market, overnight market involves shortest period of loan which is repaid back by the borrower at the start of next business day.
The overnight market mainly involves banks which need money on urgent basis for shortest period of time i.e. only for “overnight”. The rate charged by the lender in the overnight market is normally very low and is called as “overnight interest rate”. In fact, overnight interest rate is the lowest interest rate at which banks deal in borrowing or lending among themselves. Apart from big financial institutions, banks are only ones who largely deal in overnight market. Liquidity need or demand and supply of money in overnight market rise and fall over the course of the business day. Depending on the liquidity in the market, the overnight interest rate fluctuates. It may shoot up, if there is heavy liquidity crunch in the economy.
A bank or any large financial institution does not borrow the money blindly in overnight market. But lot of pre-analysis and forecasting is done by a group regarding liquidity needed. Each bank or financial institutions owns such group which exclusively works for smart cash management. The cash management group basically predicts or forecasts the client requirements just before the initiation of next business day.
Anticipated cash projection allows the bank or financial institution to decide whether to borrow or lend the money in overnight market. If the projection indicates that bank’s clients will withdraw more money due to which the bank will need more liquidity as compared to its current figure on hand, the borrower bank will approach other lender banks in overnight market to borrow the needed amount for that business day at prevailing overnight interest rate. Contrary to this, if the bank has anticipated surplus amount on hand at the start of business day, it will plan to lend the extra money to some other financial institution or bank which needs more liquidity.
Sometimes the forecast done by cash management groups fail and the anticipation falls short. The borrower bank is left with more liquidity or lender bank feels the shortage of liquidity during the course of business day. Once the financial institution or bank finds that it needs more money as compared to anticipated amount over the course of day, it will borrow the sudden needed money from the overnight market and fulfill the request of its valuable clients. On the other hand, if the bank is left with more money as compared to projected amount, it will lend the surplus money at overnight interest rate in overnight market.
Normally central banks declare the overnight interest rate once a month along with its range or bandwidth. The overnight interest rate fluctuates within this target bandwidth for that respective month. Whenever the central bank finds that the overnight interest rate may go beyond this bandwidth, it ensures that the interest rate stays within the announced range. Sometimes the central bank even uses its cash reserves in overnight market either to lend or borrow in order to avoid the overnight interest rate from deviating out of its bandwidth for each month.