Broadly speaking, at the money market banks exchange short-term loans and deposits. The reasons for this are different, but they are usually associated with the management of required reserves at the central bank, investing of borrowed funds, obtaining funding to cover any liabilities, etc. Usually banks that have excess funds provide unsecured loans to those who need additional liquidity. Banks have agreed limits to each other and within these limits they exchange the necessary funding. The maturity of these deposits is usually up to one year, most of them up to one week and usually overnight (O/N). Banks are constantly provide quoting for the money market instruments, and these transactions are carried out by telephone, Reuters or Bloomberg terminals and various electronic platforms.
Major money market indicators
The most common indicator that reflects what is happening in the interbank money market is called the London Interbank Offered Rate (LIBOR). It is calculated daily by the British Banking Association (BBA) and is published at 11:30 London time by Thomson Reuters. LIBOR shows what interest have to pay the banks if they want to get funding from another bank. Leading banks submit this information to the BBA and after excluding the highest and lowest 25% of the data, the rest are averaged.
Government bonds rates
Almost every government issues bonds, and with the funds received they cover their public expenses. These bonds are purchased from a variety of investors, which are often from other countries. For this reason, with the buying and selling of government bonds are connected part of the transactions of the foreign exchange market. This way the foreign exchange rates are influenced by the supply and demand of bonds and it's good to keep this fact in mind. Moreover, especially in times of financial crisis, the yields of these bonds reflect the investor sentiment towards the issuing country and can give early warning signals about the direction of the movement of a currency pair.
Interest rate differentials
At the Forex market are traded currency pairs, and we always have to buy one currency against another. In order to get some idea of the direction in which a currency pair is expected to move, we have to use the difference between the interest rates on the two currencies. This difference between the interest rates is called interest rate differential. The general rule is that the currency with a higher interest rate has to appreciate against the currency with the lower interest rate.
The LIBOR-OIS spread represents the difference between the LIBOR and an overnight index swap (OIS). The OIS is a derivative of an overnight interest rate and shows what are the market expectations to be the value of this interest rate for the time to maturity of this contract. This spread is used to assess the risk in the interbank money market. Basically all interest rates are affected by the monetary policy of the central banks and when they cut or hike their key rates the LIBOR and OIS change respectively. When there is an increased risk in the banking system, and banks do not trust each other, they build a risk premium in their quotes. For this and some other reasons, the difference between LIBOR and OIS gives us what risk premium is built in the cost of bank financing.
The FX swaps are also derivatives, and are actually an exchange of cash flows of any currency pair. In practice, swaps can be structured on everything that can be exchanged, but we are more interested in the FX swaps. In such transactions there is simultaneous buying and selling of two currencies with two different value date. The closer value date usually is spot while the farther is forward. It is possible both to value dates to be forward (ie more than 2 days). Each transaction is called a leg and is executed at the market rate for the respective value date. If the first leg is for spot value date the deal will be done at the current spot rate. If the second leg is for one month the deal will be executed at the forward exchange rate for the same maturity.
Basis Currency Swaps
If a money market crisis lasts longer and also it is not likely to be resolved soon, traders are turning their attention to the so-called basis currency swaps. These financial instruments are mainly used when market participants seek funding or hedge currency exposure for periods of one year or more. For the structuring of basis currency swaps cash flows in two different currencies are exchanged, but they have some differences with the standard swaps. Principals are exchanged at the beginning and at the maturity of the swap. During the time between these two dates are exchanged floating interest payments. Usually they are based on Libor or another interbank index. Spread is added to the market rates, which is the price of the swap. Amounts that are exchanged on the maturity of the basis swap are fixed in advance, so there is no currency risk, allowing these instruments to be used for hedging. Basis swaps have many characteristics in common with the conventional FX swaps. The main difference is that for the standard swaps the interest rates are fixed for the period to maturity at the outset by the swap numbers.