The LIBOR-OIS spread is an important concept to understand because it plays a vital roll to determine the health of the credit markets that many economists and analysts watch regularly. So let’s take a look at what the LIBOR-OIS is all about.
Three-month LIBOR is a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank.
The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate. 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 to borrow at a fixed rate of interest over the same period.
There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other.
Furthermore, former Fed Chairman Alan Greenspan stated recently that the “LIBOR-OIS remains a barometer of fears of bank insolvency.” There is no doubt that changes in the LIBOR-OIS spread reflect counterparty credit risk premiums in contrast to liquidity risk premiums.
It appears that the spreads reflect the market’s perception of increased risk endemic to the economy more generally. These measures are telling investors to be very careful. Since September 2009, the TED Spread has typically ranged between 10 and 20 basis points. During economic crisis it gets much higher. It spiked as high as 457 basis points in the fall of 2008, when Lehman and Bear Stearns were collapsing.
In short, the LIBOR-OIS spread has been the summary indicator showing the “illiquidity waves” that severely impaired money markets in 2007 and 2008.