LIBOR-OIS spread must read

Economic SYNOPSES
short essays and reports on the economic issues of the day
2008 􀀀 Number 25
The LIBOR-OIS spread has been a closely watched
barometer of distress in money markets for more than
a year. The 3-month London Interbank Offered Rate
(LIBOR) is the interest rate at which banks borrow unsecured
funds from other banks in the London wholesale money market
for a period of 3 months. Alternatively, if a bank enters into
an overnight indexed swap (OIS), it is entitled to receive a fixed
rate of interest on a notional amount called the OIS rate. In
exchange, the bank agrees to pay a (compound) interest payment
on the notional amount to be determined by a reference
floating rate (in the United States, this is the effective federal
funds rate) to the counterparty at maturity. For example, suppose
the 3-month OIS rate is 2 percent. If the geometric average
of the annualized effective federal funds rate for the 3-
month period is 1.91 percent, there will be a net cash inflow
of $2,250 on a principal amount of $10 million [(2 percent –
1.91 percent) × 3/12 × $10 million = $2,250] to the bank from
its counterparty.
A bank borrowing at the 3-month LIBOR rate of 2.10
percent that enters into a swap to receive at the 3-month OIS
rate of 2 percent has a borrowing cost equal to the effective
federal funds rate plus 10 basis points. Entering into the OIS
exposes the bank to future fluctuations in the
reference rate. However, the bank can guarantee
itself longer-term funding while still paying close
to the overnight rate. Because the alternative
would be rolling over the funds on a daily basis at
changing overnight rates, banks are willing to pay
a premium. This is reflected in the LIBOR-OIS
spread (defined as the difference between the
LIBOR rate and the OIS rate) shown in the chart.
In times of stress, the LIBOR, referencing a cash
instrument, reflects both credit and liquidity
risk,1 but the OIS has little exposure to default
risk because these contracts do not involve any
initial cash flows. The OIS rate is therefore an
accurate measure of investor expectations of the
effective federal funds rate (and hence the Fed’s
target) over the term of the swap, whereas LIBOR
reflects credit risk and the expectation on future
over night rates.
Before the onset of the turmoil in the credit markets in
August 2007, the LIBOR-OIS spread was around 10 basis
points. However, in just over a month, the spread rose to 85
basis points on September 14, 2007, when the Bank of England
announced emergency funding to rescue the troubled Northern
Rock, one of the U.K.’s largest mortgage lenders. The spread
reached its all-time high at 108 basis points on December 6,
2007. Around the same time, large investment banks such as
UBS and Lehman Brothers announced huge write-downs. On
March 17, 2008, the collapse of Bear Stearns led to an 83-basispoint
spread, a 19-basis-point increase from the previous
trading day. In the latest illiquidity wave following the failure
of Lehman Brothers, the spread was 365 basis points (as of
October 10, 2008). In short, the LIBOR-OIS spread has been
the summary indicator showing the “illiquidity waves” that
severely impaired money markets in 2007 and 2008. 􀀀
1 Liquidity risk is the risk that a bank could not convert its assets into cash,
whereas credit risk is the risk that it could fail to meet its contractual obligations.
Some have claimed that this distinction is unclear and that, particularly in the
case of financial institutions, “the definition of liquidity is elusive.” See von Thadden,
Ernst-Ludwig. “Liquidity Creation Through Banks and Markets: Multiple Insurance
and Limited Market Access.” European Economic Review, April 1999, 43(4-6),
pp. 991-1006.
The LIBOR-OIS Spread as a Summary Indicator
Rajdeep Sengupta and Yu Man Tam
research.stlouisfed.org
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
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3-Month LIBOR-OIS Spread
September 14, 2007
Northern Rock Crisis
December 10, 2007
Bank Writedowns
March 17, 2008
Collapse of
Bear Stearns
October 10, 2008
Global Banking Crisis