Within the money market, there is one segment of particular interest for central bankers as it is directly (or indirectly) affected by the liquidity policy of the central bank: the overnight market. For central banks which implement monetary policy by steering short term money market interest rates, the overnight interest rate plays a key role in signalling the stance of monetary policy. It is therefore essential for the overnight interest rate to stand close to the key policy rate determined by the decision making body of central banks and for its volatility to remain well contained.
In the specific case of the twelve Member States sharing the euro (i.e. the so called euro area), the evolution of rates in the overnight segment is mostly conditioned to the results of the regular refinancing operations conducted by the European Central Bank (ECB). With the launch of the European single currency, the money markets of those Member States have converged into a single market with a single operational framework of the monetary policy, in which the allotment decisions are centralised but their execution is decentralised.
The Eurosystemjs operational framework the procedures and rules governing the implementation of monetary policy was also designed with the desire to ensure that the volatility of the overnight rate does not reach levels which would blur the crucial signalling mechanism. Consequently, since 4 January 1999, money markets in the euro area have been unified with homogeneous price references for maturities from overnight to one year in the twelve Member States sharing the euro.
Over eight years of existence, the monetary policy operational framework in the euro area has registered several changes as regards the number of counterparties, the type of the allotment policy and the structure of the framework itself. Some changes were implemented by the ECB itself in order to contribute to a smooth evolution of rates in the overnight market through the (reserve) maintenance period, i.e. the period during which a certain amount of reserves is required to be held with the national central banks of the euro area, namely the Eurosystem.
Against this background, it is particularly interesting to investigate how the changes which have occurred in the operational framework may have influenced the volatility of the overnight interest rate and whether the latter has impacted the volatility of interest rates at longer maturities in the money market. In line with Andersen and Bollerslev (1997) and Andersen and Bollerslev (1998a), the analysis is focused on the concept of realised volatility using intraday observations. Similar approach is used to test the potential spill$over of the volatility of the overnight interest rate on the volatility of longer term interest rates in the money market. The related question is then to verify the expected neutrality of the liquidity policy. Given the objective of the paper, it appears indeed adequate to use a model free measure of volatility, which is closer to the observed volatility and less conditional to any model specifications.
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Volatility in the euro area money market: Effects from the monetary policy operational framework
