An overnight indexed swap (OIS) is an

interest rate swap In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...

(''IRS'') over some given term, e.g. 10Y, where the periodic fixed payments are tied to a given fixed rate while the periodic floating payments are tied to a floating rate calculated from a daily compounded

overnight rate The overnight rate is generally the interest rate that large banks use to borrow and lend from one another in the overnight market. In some countries (the United States, for example), the overnight rate may be the rate targeted by the central ba ...

over the floating coupon period. Note that the OIS term is not overnight; it is the underlying

reference rate A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house pric ...

that is an

. The exact compounding formula depends on the type of such overnight rate. The index rate is typically the rate for overnight lending between banks, either non-secured or secured, for example the

Federal funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an collateral (finance), uncollateralized basis ...

SOFR Secured Overnight Financing Rate (SOFR) is a secured overnight rate, overnight interest rate. SOFR is a reference rate (that is, a rate used by parties in commercial contracts that is outside their direct control) established as an alternative to L ...

for US dollar, €STR (formerly EONIA) for Euro or SONIA for sterling. The fixed rate of OIS is typically an interest rate considered less risky than the corresponding interbank rate (

LIBOR The London Inter-Bank Offered Rate (Libor ) was an interest rate average calculated from estimates submitted by the leading Bank, banks in London. Each bank estimated what it would be charged were it to borrow from other banks. It was the prim ...

) because there is limited counterparty risk.

LIBOR–OIS spread

The LIBOR–OIS spread is the difference between IRS rates, based on the

, and OIS rates, based on overnight rates, for the same term. The spread between the two rates is considered to be a measure of health of the banking system.Sengupta, Rajdeep and Yu Man Tam. (2008) The LIBOR–OIS Spread as a Summary Indicator. Economic Synopses, Number 25, 2008. Federal Reserve Bank of St. Louis
/ref> It is an important measure of risk and liquidity in the money market, considered by many, including former

US Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...

chairman

Alan Greenspan Alan Greenspan (born March 6, 1926) is an American economist who served as the 13th chairman of the Federal Reserve from 1987 to 2006. He worked as a private adviser and provided consulting for firms through his company, Greenspan Associates L ...

, to be a strong indicator for the relative stress in the

money market The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less. As short-term securities became a commodity, the money market became a compo ...

s. A higher spread (high Libor) is typically interpreted as indication of a decreased willingness to lend by major

bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...

s, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the

creditworthiness Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal sum, principal payment, leading to disrupted Cash flow, cash flows and increased Colle ...

of other financial institutions and the general availability of funds for lending purposes. The LIBOR–OIS spread has historically hovered around 10

basis point A basis point (often abbreviated as bp, often pronounced as "bip" or "beep") is one hundredth of 1 percentage point. Changes of interest rates are often stated in basis points. For example, if an existing interest rate of 10 percent is increased ...

s (bps). However, during the

2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...

, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe

credit crunch A credit crunch (a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally ...

. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10–15 basis points by September 2009.

Risk barometer

3-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 A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...

. The OIS allows LIBOR-based 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 Eurodollars are U.S. dollars held in time deposit accounts in banks outside the United States. The term was originally applied to U.S. dollar accounts held in banks situated in Europe, but it expanded over the years to cover US dollar accounts ...

rate and the Federal Reserve's

Fed Funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...

. 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 Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...

premiums'' in contrast to ''

liquidity risk Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price. Types Market liquidity – An asset cannot be ...

premiums''. 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 . This changed abruptly, as the spread jumped to a rate of around 50 in early August 2007 as the financial markets began to price in a higher risk environment. Within months, the

Bank 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 to act as the Kingdom of England, English Government's banker and debt manager, and still one ...

was forced to rescue

Northern Rock Northern Rock, formerly the Northern Rock Building Society, was a British bank. Based at Regent Centre in Newcastle upon Tyne, United Kingdom, Northern Rock was originally a building society. It demutualised and became Northern Rock bank in ...

from failure. The spread continued to maintain historically high levels as the

crisis A crisis (: crises; : critical) is any event or period that will lead to an unstable and dangerous situation affecting an individual, group, or all of society. Crises are negative changes in the human or environmental affairs, especially when ...

continued to unfold. As markets improved, the spread fell and as of October 2009, stood at 10 once again, only to rise again as struggles of the PIIGS countries threatened European banks. The spread varied from 10 to 50 bps up through February 2018. As of March 2018, the spread again stands at 50+ bps level. Whilst liquidity is provided in excess by monetary policy authorities the LIBOR-OIS is less of an indicator of stress.

References

External links

Dollar Libor–OIS Spread at 2-Year High Amid Europe Bank Concern
{{Reference rates Derivatives (finance) Reference rates Swaps (finance)

LIBOR–OIS spread

Risk barometer

Historical levels

See also

References

External links