LIBOR-OIS spread
Encyclopedia
The LIBOR–OIS is the difference between LIBOR
and the overnight indexed swap
(OIS) rates. The spread between the two rates is considered to be a measure of health of the banking system.
derived from the overnight rate, which is generally fixed by the local central bank
. The OIS allows LIBOR banks to borrow at a fixed rate of interest over the same period. In the United States the spread is based on the LIBOR Eurodollar
rate and the Federal Reserve's
Fed Funds rate
.
LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is considered stable as both counterparties
only swap the floating rate of interest for the fixed rate of interest. The spread between the two is therefore a measure of how likely borrowing banks will default. This reflects counterparty credit risk premiums in contrast to liquidity risk premiums.
was forced to rescue Northern Rock
from failure. The spread continued to maintain historically high levels as the crisis
continued to unfold.
As markets improved, the spread fell and as of October 2009, stood at 10 bps once again, only to rise again as struggles of the PIIGS countries threatened European banks.
London Interbank Offered Rate
The LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
and the overnight indexed swap
Overnight indexed swap
An overnight indexed swap is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index over every day of the payment period...
(OIS) rates. The spread between the two rates is considered to be a measure of health of the banking system.
Risk barometer
Three-month LIBOR is generally floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The OIS is a swapInterest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
derived from the overnight rate, which is generally fixed by the local central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
. The OIS allows LIBOR banks to borrow at a fixed rate of interest over the same period. In the United States the spread is based on the LIBOR Eurodollar
Eurodollar
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term...
rate and the Federal Reserve's
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
Fed Funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
.
LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is considered stable as both counterparties
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
only swap the floating rate of interest for the fixed rate of interest. The spread between the two is therefore a measure of how likely borrowing banks will default. This reflects counterparty credit risk premiums in contrast to liquidity risk premiums.
Historical levels
In the United States, the LIBOR–OIS spread generally maintains around 10 bps. This changed abruptly, as the spread jumped to a rate of around 50bps in early August 2007 as the financial markets began to price in a higher risk environment. Within months, the Bank of EnglandBank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...
was forced to rescue Northern Rock
Nationalisation of Northern Rock
In 2008 the Northern Rock bank was nationalised by the British Government, due to financial problems caused by the subprime mortgage crisis...
from failure. The spread continued to maintain historically high levels as the crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
continued to unfold.
As markets improved, the spread fell and as of October 2009, stood at 10 bps once again, only to rise again as struggles of the PIIGS countries threatened European banks.