What Is the Canadian Overnight Money Market Rate?
The Canadian overnight money market rate is a measure or estimate of the rate at which major dealers can arrange the financing of securities inventory for one business day. It is compiled by the Bank of Canada at the end of the day based on a survey of major participants in the overnight market.
Understanding the Canadian Overnight Money Market Rate
The Canadian overnight money market rate represents the weighted-average repo funding cost of major money market dealers. It is a less volatile measure of the collateralized overnight rate compared to other rates because it includes a greater volume of overnight transactions from more participants.
The central bank carries out monetary policy by influencing short-term interest rates. The bank raising and lowers the target for the overnight rate. The overnight rate is rate at which major financial institutions borrow and lend one-day (overnight) funds to and from each other; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank's policy interest rate.
The Effect of Changes in the Overnight Rate
Changes in the target for the overnight rate influence other interest rates. Consumer loans and mortgages, for example. They also affect the exchange rate of the Canadian dollar. In November 2000, the Bank decided to make announcements concerning any policy interest rate changes on eight pre-determined dates each year.
Canada’s major financial institutions borrow and lend money overnight among themselves to cover their transactions at the end of the day. Through the Large Value Transfer System (LVTS), these institutions conduct large transactions electronically. At the end of the day, traders must settle with each other. While one bank may have excess funds at the end of the day's trading, another bank may need money, and this trading of funds represents the overnight market. The overnight rate is the interest charged on those loans.
The Overnight Rate Operating Bands
The Bank of Canada has a system of an "operating band" for overnight trading.” This band is one-half of a percentage point wide and at the center of the bank is the target for the overnight rate. For example, if the operating band is from 2.25 to 2.75%, the target for the overnight rate is 2.5%. The top of that band, 2.75%, is the bank rate—the interest rate that the bank charges on one-day loans to LVTS participants. The bottom of the band, 2.25%, is the deposit rate—the interest rate that the bank pays on any surplus left on deposit overnight at the bank.
Since LVTS participants know that the Bank of Canada will always lend them money at the top rate of the band and will pay interest on deposits at the bottom rate of the band, there is no reason to trade at rates outside the band. The Bank can also intervene in the overnight market at the target rate if the market rate is moving away from the target. The target for the overnight rate is the favored rate for international comparisons. It is considered comparable with the U.S. Federal Reserve’s target for the Federal funds rate, the Bank of England’s two-week “repo rate” and the minimum bid rate for refinancing operations (the repo rate) of the European Central Bank.
Any changes in the target for the overnight rate will influence market interest rates and is considered an indicator of the direction of short-term interest rates. In addition, changes in the target rate usually lead to moves in the prime rate of commercial banks.