Arbitrage, Liquidity and Exit: The Repo and Federal Funds Markets Before, During, and Emerging from the Financial Crisis

55 Pages Posted: 10 May 2012 Last revised: 23 May 2012

See all articles by Elizabeth Klee

Elizabeth Klee

Board of Governors of the Federal Reserve System

Viktors Stebunovs

Board of Governors of the Federal Reserve System

Morten L. Bech

Bank for International Settlements (BIS) - Committee on Payments and Market Infrastructures

Multiple version iconThere are 2 versions of this paper

Date Written: February 3, 2012

Abstract

This paper examines the link between the federal funds and repo markets, before, during, and emerging from the financial crisis that began in August 2007. In particular, the paper investigates the initial transmission of monetary policy to closely related money markets, pricing of risk, and liquidity effects, and then shows how these could interact if the Federal Reserve removes the substantial amount of liquidity currently in the federal funds market. The results suggest that pass-through from the federal funds rate to the repo deteriorated somewhat during the zero lower bound period, likely due to limits to arbitrage and idiosyncratic market factors. In addition, during the early part of the crisis, the pricing of federal funds, which are unsecured loans, indicated a marked jump in perceived credit risk. Moreover, the liquidity effect for the federal funds rate, or the change in the federal funds rate associated with an exogenous change in reserve balances, weakened greatly with the increase in supply of these balances over the crisis, implying a non-linear demand for federal funds. Using these analyses, the paper then shows simulations of the dynamic effects and balance sheet mechanics of liquidity draining on the federal funds and repo rates -- a tool that might be used in an exit strategy to tighten monetary policy.

Keywords: Repurchase agreement, federal funds, financial crisis, monetary policy implementation, exit strategy

JEL Classification: E52, E58, G01

Suggested Citation

Klee, Elizabeth and Stebunovs, Viktors and Bech, Morten L., Arbitrage, Liquidity and Exit: The Repo and Federal Funds Markets Before, During, and Emerging from the Financial Crisis (February 3, 2012). FEDS Working Paper No. 2012-21, Available at SSRN: https://ssrn.com/abstract=2055188 or http://dx.doi.org/10.2139/ssrn.2055188

Elizabeth Klee (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th and Constitution Ave NW
Washington, DC 20551
United States

Viktors Stebunovs

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States

Morten L. Bech

Bank for International Settlements (BIS) - Committee on Payments and Market Infrastructures ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland
41612808923 (Phone)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
104
Abstract Views
888
rank
226,749
PlumX Metrics