LIBOR–OIS spread
 | It has been suggested that this article be merged into Overnight indexed swap. (Discuss) Proposed since December 2009. |
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.[1]
Risk barometer
Three-month LIBOR is generally a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR-based banks (i.e. banks that can borrow at the LIBOR - in fact not all banks can) 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.[2]
LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is stable in the sense that 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.[1] However, given the mismatch in the tenor of the funding, it also reflects worries about liquidity risk as well.
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 50 bps in early August 2007 as the financial markets began to price in a higher risk environment. Within months, the Bank of England was forced to rescue Northern Rock from failure. The spread continued to maintain historically high levels as the crisis continued to unfold.[2]
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. As of December 2011, the spread again stands at 40+ bps level.