Since the late 1980s, the liquidity of the Eurodollar CD has increased significantly and the perception of higher risk had diminished. Exhibit 6.3 presents a time series plot of the spread (in basis points) between 3-month LIBOR and 3-month CDs for the period January 1991 to October 2001.1

1Source: Federal Reserve Statistical Release H.15. The CD rates are an average of dealer offering rates on nationally traded CDs.

The rates are sampled every Friday. The patterns evident from the graph are consistent with Eurodollar CDs and domestic CDs being viewed as close substitutes. The mean spread over this time period is 11.09 basis points. The large negative spike (-33 basis points) on the right-hand of the graph is from September 14, 2001 which was the first Friday observation after the terrorist attacks of September 11, 2001. Given the extraordinary circumstances of this week, this observation can be viewed as an outlier.

FEDERAL FUNDS

Depository institutions are required to hold reserves to meet their reserve requirements. The level of the reserves that a depository institution must maintain is based on its average daily deposits over the previous 14 days. To meet these requirements, depository institutions hold reserves at their district Federal Reserve Bank. These reserves are called federal funds.

Because no interest is earned on federal funds, a depository institu- tion that maintains federal funds in excess of the amount required incurs an opportunity cost of the interest forgone on the excess reserves. Corre- spondingly, there are also depository institutions whose federal funds are short of the amount required. The federal funds market is where deposi- tory institutions buy and sell federal funds to address this imbalance. Typ- ically, smaller depository institutions (e.g., smaller commercial banks, some thrifts, and credit unions) almost always have excess reserves while money center banks usually find themselves short of reserves and must make up the deficit. The supply of federal funds is controlled by the Fed- eral Reserve through its daily open market operations.

Most transactions involving federal funds last for only one night; that is, a depository institution with insufficient reserves that borrows excess reserves from another financial institution will typically do so for the period of one full day. Because these reserves are loaned for only a short time, federal funds are often referred to as "overnight money."

One way that depository institutions with a required reserves deficit can bring reserves to the required level is to enter into a repurchase agree-