Volatility in Money Markets

In the previous articles, we have learned about how the money market is just like any other financial market. This means that just like other markets, speculators also form a significant portion of investors in the money market. As a result, the money market also has a certain amount of volatility just like other markets.

However, this volatility needs to be controlled within certain limits. Uncontrolled volatility can wreak havoc on the markets.

In this article, we will understand the root cause of volatility in the money market as well as how this volatility affects the market.

Why Does Volatility Occur in the Money Market?

Just like any other market, volatility in the money market is also caused by differences of opinion between traders.

Generally, traders have different views as to what the future interest rates will be. As a result, based on their own analysis and understanding, traders tend to take positions. Since traders are continuously evaluating their positions in the light of emerging information, they often increase or decrease their exposure based on the available information at that time.

Since investors are constantly adjusting their positions, the price keeps changing continuously giving rise to volatility. To some extent, volatility is important since it creates an entry and exit opportunities for investors.

The Different Types of Volatility

An important point to be noted is that different types of money markets have different volatility patterns. This is because central banks as well as market regulators have an inordinate amount of power and control in such markets.

Therefore the actions of central banks and regulators can cause significant volatility in the market. This can be better understood with the help of examples.

1. In some cases, central banks have given standard instructions to their open market committee to intervene and adjust the interest rates if they go beyond a certain rate.

   Central banks fix a ceiling as well as a floor which they may or may not disclose. However, market participants are able to gauge these limits based on the actions of the central bank.

   Now, whenever the interest rate gets close to either the perceived floor or the perceived ceiling, the market participants spring into action and start conducting more trades. The end result is that more volatility is seen during such phases.

2. In some other cases, central banks, as well as regulators, intervene only on a periodic level. This means that they only make interventions based on a time schedule. In such cases, there is heightened volatility in the money markets around the time when an interest rate announcement is about to be made.

   For instance, let’s assume that the central bank is likely to intervene next month by raising interest rates in the market. In such cases, most firms will try to borrow money with maturities for more than one month in order to lock in the lower interest rates for themselves. However, they will lend their own money for less than a month so that they have the cash in hand to benefit by lending at a higher interest rate. This also tends to cause extreme volatility in the market.

It would be incorrect to say that the actions of the central bank and the regulator are the only reason behind the increase in volatility in the money markets. However, it is undoubtedly the most significant reason.

How Volatility Affects the Market?

Some volatility is important since it aids the market. However, excessive volatility negatively impacts the market in the following ways.

1. Increased volatility means increased uncertainty for the investors. Volatility is considered to be a measure of risk. Hence, increased volatility increases the cost of participation.

   Investors have to be prepared to absorb more losses due to volatility or they must also be prepared to take some form of insurance. Both of these actions cost money and hence add to the total cost of trading

2. Money market volatility means that the prices of money market instruments start fluctuating in the short run.

   The entire reason investors prefer money markets is that the value of their investments is likely to remain unchanged. If this is not the case, investors do not have an incentive to keep their money locked in money market instruments. Therefore, if volatility keeps on increasing over a sustained period of time, then money starts flowing out of the money market which is detrimental to its existence in the long run.

3. Volatility may continue to impact the market even in the long run. Once the investors have experienced a certain amount of volatility and its negative consequences, then they are likely to be afraid over a longer period of time.

The bottom line is that a certain amount of volatility is good for the market. In fact, there are some patterns of volatility that the market has already adjusted to. However, if this volatility is sustained over a longer period of time, then it can have a significant negative impact on the overall money market.