"Hot money" refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. A typical short-term investment opportunity that often attracts "hot money" is the certificate of deposit (CD).
How Does the 'Hot Money' Concept Work?
Banks usually attract "hot money" by offering relatively short-term certificates of deposit that have above-average interest rates. As soon as the institution reduces interest rates or another institution offers higher rates, investors with "hot money" withdraw their funds and move them to another institution with higher rates.
The "hot money" concept is not reserved solely for banks. Investors can move their funds to different countries to take advantage of favorable interest rates.
The Impact of 'Hot Money' on Countries and Banks
"Hot money" can have economic and financial repercussions on countries and banks, however. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds.
(To read more about CDs, see Step up Your Income With a CD Ladder.)