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 ban ...

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

SOFR Secured Overnight Financing Rate (SOFR) is a secured interbank 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 LIBOR. ...

for US dollar, €STR (formerly EONIA) for Euro or

SONIA Sonia, Sonja or Sonya, a name of Greek origin meaning wisdom, may refer to: People * Sonia (name), a feminine given name (lists people named, Sonia, Sonja and Sonya) :* Sonia (actress), Indian film actress in Malayalam and Tamil films :* 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 is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...

) because there is limited counterparty risk. 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 of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after ...

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 works as a private adviser and provides consulting for firms through his company, Greenspan Associates LLC. ...

, to be a strong indicator for the relative stress in the money markets. 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 A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

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. The related term ''permyriad'' means one hundredth of 1 percent. Changes of interest rates are often stated in basis points. If ...

s (bps). However, in the midst of the

financial crisis of 2007–2010 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...

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

credit crunch A credit crunch (also known as 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 cr ...

. 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, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...

. 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 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 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 s ...

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 English Government's banker, and still one of the bankers for the Government o ...

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 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)

Risk barometer

Historical levels

See also

References

External links