Spread, volatility and monetary policy: empirical evidence from the Indian overnight money market

Abstract

This study uses a GARCH model to estimate conditional volatility in the Indian overnight money market during the period 1999–2006. It finds that the bid-ask spread in the overnight market was positively related to conditional volatility during 1999–2002. This relationship, however, has undergone a structural break since 2002 and lagged spread, along with conditional variance of the call rate, played an important role in determining spread during 2002–2006, indicating the improvement in market microstructure in recent years. Regarding monetary policy measures and money market volatility, the empirical findings indicate that expansionary monetary policy reduces volatility of both the weighted average call rate and the bid-ask spread. Among individual policy instruments, announcement of cash reserve ratio changes have a negative impact on the volatility of both call rate and spread. The other policy variables like Bank Rate, repo and reverse repo rates have a mixed impact on volatility of call rate and spread.

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